22 May 2020

Credit Crunch

Why is it news?

ILFS crisis and consequent credit crunch in the shadow banking system

What is it?

  • The credit crunch refers to a sudden shortage of funds for lending, leading to a decline in loans available. It is also called a credit squeeze or credit crisis.

A credit crunch can occur for various reasons:

  • A sudden increase in interest rates (e.g. in 1992, UK government increased rates to 15%)
  • Direct money controls by the government (rarely used by Western Governments these days)
  • A drying up of funds in the capital markets
  • Reasons for recent credit crunch→ A drying up of funds in the capital markets→ this is because of the following reasons
  • IL&FS crisis → consequent liquidity crisis(Liquidity crisis is a temporary issue whereas credit crunch persists relatively for a longer period)
  • NBFCs are becoming risk-averse and trying to preserve cash in their books.
  • Mutual funds have stayed away from lending to NBFCs as they are facing redemption pressure leading to bottlenecks in lending
  • NBFCs have found it difficult to raise capital through debt markets and banks are not willing to roll on NBFCs with large wholesale exposure.
  • As lending costs have gone up and lending lines have squeezed, NBFCs are resorting to lending to high margin categories
  • Reluctance on the part of banks to continue with the existing lending arrangements to NBFCs.
  • There have been instances of banks withdrawing unutilized lines of credit or showing apprehension towards renewal or rolling over existing credit lines
  • The overall slowdown in the economy

What is Shadow banking?

  • The shadow banking system is a term for the collection of non-bank financial intermediaries that provide services similar to traditional commercial banks but outside normal banking regulations.
  • The shadow banking system (or shadow financial system) is a network of financial institutions comprised of non-depository banks — e.g., non-bank financial institutions, investment banks, hedge funds, and money market funds. Shadow banking in India loosely refers to NBFCs/NBFIs.

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