2015 Series • No. 2015–5
Current Policy Perspectives
Credit Supply Disruptions: From Credit Crunches to Financial Crisis 
Events that transpired during the recent financial crisis highlight the important role that financial intermediaries still play in the economy, especially during economic downturns. While the breadth and severity of the financial crisis took most observers by surprise, it has renewed academic interest in understanding the effects on the real economy of both financial shocks and the changing nature of financial intermediation. This interest in the real effects of financial shocks highlights a literature that began more than 20 years ago associated with the bank credit crunch of the early 1990s. It is useful to reflect on what we thought we had learned from that research and how that research has helped to guide policy in the more recent crisis.
Key Findings
- The earlier literature on credit crunches contributed importantly to economists’ understanding of how financial shocks can impact the real economy. The real estate shock that caused capital-constrained banks to reduce credit availability to households and firms provided an important lesson learned from the 1990 recession and the academic work that followed. That literature provided a helpful guide as to how to respond to adverse credit shocks.
- However, many of the financial innovations that occurred after the 1990 recession moved much of the issuance of credit to non-depository financial intermediaries. These intermediaries included money market mutual funds, broker-dealers, and issuers of asset-backed securities.
- While the main problem facing banks was how to satisfy capital constraints when experiencing large declines in capital, these nonbank intermediaries were much more susceptible than banks to liquidity shocks, runs on liabilities, and fire sales of assets. Although the earlier literature provided important context, the nature of the problems was quite different for non-depository entities. Because these potential problems of nonbank intermediaries had not arisen in the earlier credit crunch, they were largely ignored in the subsequent credit crunch literature.
Exhibits
Implications
Significant regulatory improvements are being implemented for banks. However, for non-depository institutions, much remains to be done. Both policymakers and academics need to better understand the complex interaction of the traditional banking system with shadow banks if we are to be confident that the U.S. economy would be resilient to a future adverse financial shock of a similar magnitude.
Abstract
It is useful to reflect on how the financial environment changed in the interim between the bank credit crunch episode in the early 1990s and the recent financial crisis. What did we learn from the earlier crisis and how did the credit crunch literature help guide policy in the more recent crisis? Among the important changes were the consolidation of the banking sector and the dramatic growth in nonbank financial intermediaries, which are much more susceptible than banks to liquidity risks due to a lack of deposit insurance. This paper highlights the fact that while broker-dealers, money market mutual funds, and issuers of asset-backed securities were not particularly important in the early 1990s when the bank credit crunch occurred, they had grown dramatically over the subsequent two decades to become both a major source of financing and a key element in exacerbating the problems experienced during the recent financial crisis.