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What are the causes of the credit crunch

what are the causes of the credit crunch

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Economic Review — Third Quarter 1993

Robert T. Clair

Senior Economist and Policy Advisor

Federal Reserve Bank of Dallas

Paula Tucker1


University of Texas at Austin Law School

the cause of the credit crunch. Like the blind men

examining an elephant, each has an opinion that

has been formed from his perspective. Each has

characterized the problem and potential solutions

differently. None are completely correct or com-

pletely wrong. Bankers cite the lack of high quality

loan demand. Legislators blame overzealous regu-

lators. Borrowers say banks are too conservative.

Regulators encourage bankers to lend and tell

their examination staffs to facilitate the extension

of credit but maintain the safety and soundness of

the banking system.

Many economists studying the credit crunch

explain it as a cyclical decline in credit demand.

They often suggest that the cyclical swing is

reinforced by structural changes in the demand

for credit. These economists have minimized the

numerous important factors that have reduced the

ability of banks to supply credit or, at a minimum,

have increased the cost of providing it.

In this article, we view credit crunches as

localized events that occur at different times in

different parts of the country. The Texas banking

industry provides an important case study. The

causes of the Texas credit crunch are highly

similar to the causes of credit crunches that have

developed elsewhere in the country. We focus on

the past seven years because the contraction of

bank credit began in Texas in 1986.

While demand may play an important part

in the decline in loans outstanding during some of

this period, we focus on the factors affecting the

supply of loans from banks over the past seven

years. While there are other sources of credit to

business, banks continue to be vitally important,

any bankers, legislators, borrowers, and

regulators have expressed their views about

especially to small and mid-size businesses (Ellie-

hausen and Wolken 1990). Many of the factors

that are limiting credit supply from banks also

affect other suppliers of credit. In some cases,

however, the factors limiting credit from banks are

unique to banks and place banks at a competitive

disadvantage. As discussed in the next section, the

definition of a credit crunch is fundamentally

related to the supply of credit, as opposed to the

demand for it. The following section presents the

complexity of the credit crunch as it developed in

Texas, where supply was reduced at both finan-

cially healthy and unhealthy banks. In the remain-

der of the article, we present six general factors

that caused the supply of credit to contract.

What is a credit crunch, and are we in one?

The economics profession is unclear as to

what constitutes a “credit crunch.” The crucial

differences in definition depend on the cause of

the contraction and whether credit is rationed by

means other than price.

Bernanke and Lown (1991) define a credit

crunch as a decline in the supply of credit that is

abnormally large for a given stage of the business

Federal Reserve Bank of Dallas

recent recession to those in the previous five

recessions. Total loans at domestically chartered

commercial banks grew only 1.7 percent during

the 1990–91 period, compared with an average of

7.1 percent during the previous five recessions.

They conclude that there has been a credit crunch.

Bernanke and Lown attribute this reduced

lending activity to demand and supply factors.

Loan demand has been weak because borrowers’

balance sheets have been weaker than normal,

and as a result, borrowers have been less credit-

worthy than usual. The supply of credit has been

reduced by the decline in bank capital caused by

severe loan losses during the recession (Clair and

Yeats 1991). Bernanke and Lown’s analysis indi-

cates that the demand factors have been far more

important, accounting for three-fourths of the

decline in lending in New England.

There is a disturbing dissonance created by

the Bernanke and Lown definition of a credit

crunch, the results of their analysis, and their con-

clusion that there was a credit crunch. They define

the credit crunch as an abnormally large decline

in the supply of credit. They argue that demand

factors largely caused the reduction in lending.

They then conclude that there is a credit crunch.

A second problem with the Bernanke and

Lown analysis is their use of national data to

determine if a credit crunch exists. Their cross-

sectional analysis using state-level data assumes

the imperfect substitutability of bank and nonbank

credit and of bank credit from banks located in

different states. Samolyk (1991) provides empirical

evidence supporting this assumption. If bank credit

cannot flow perfectly across state lines, however,

then the problems of a credit crunch would be

more likely to develop at the state level, not the

national level, unless a nationwide economic shock

caused the decline in bank capital.

The second definition of a credit crunch

relies not on the contraction in lending but on the

microeconomic principle of a shortage. If at the

current market price the demand for a good

exceeds the supply, then there is a shortage. The

available supply will be rationed but by some

means other than pricing. Nonprice credit rationing

may occur even in a market that might not be

described as experiencing a credit crunch (Stiglitz

and Weiss 1981). Owens and Schreft (1992) define

a credit crunch as a period of sharply increased

nonprice rationing.

Owens and Schreft review historical episodes

of nonprice rationing—that is, credit crunches that

were accompanied by binding interest rate ceilings,

credit controls, or coercive posturing by adminis-

trative officials and bank regulators to discourage

banks from lending. In the current recession,

researchers argue, administrative officials and bank

regulators have actively encouraged banks to

lend.2 Owens and Schreft do state that there was

probably nonprice rationing in loans secured by

real estate, resulting from bank examiners’ reaction

to real estate loan losses. They cite the statements

made by Robert Clarke, then comptroller of the

currency, that discouraged banks from making

real estate loans.

Owens and Schreft conclude that there is

not a general credit crunch, but there might have

been a sector–specific crunch in real estate. Since

nonbank providers of credit also contracted their

lending, Owens and Schreft attribute the decline

in lending to ebbing loan demand.

The Owens and Schreft definition of a credit

crunch has intuitive microeconomic appeal but

may not provide the insights needed for economic

policy analysis. Their definition does not consider

actual lending activity. Consequently, a “credit

crunch” can occur during a period of expanding

credit as easily as during a contraction of credit.

Furthermore, Owens and Schreft dismiss

anecdotal evidence from borrowers. They may be

correct that borrowers would complain during any

period of tight credit, but the type of complaint

could be quite different. During nonprice rationing,

borrowers complain about not being able to get a

loan at any price. During periods of simply tight

credit, borrowers complain about the cost of credit.

Economic Review — Third Quarter 1993

for the explanation that more stringent bank

examination practices account for the contraction

in loan supply. Owens and Schreft link the decline

in credit demand to the deterioration of real estate

asset values, similar to the Bernanke and Lown

view of weakened balance sheets. In determining

if the nation is in a credit crunch, Bernanke and

Lown cite the abnormally slower growth of credit

as a sign of the credit crunch, while Owens and

Schreft see few signs of nonprice credit rationing

and conclude that there is no general credit crunch.

In ascertaining that demand factors are a

primary cause of the decline in bank credit, both

studies cite the lack of credit supply response

from nonbank sources of credit. Nonbank sources

of credit to businesses are growing increasingly

important (Pavel and Rosenblum 1985). Approxi-

mately 25 percent of small and mid-size businesses

obtain credit from nonbank sources (Elliehausen

and Wolken 1990).

If bank credit alone were being rationed or

constrained, both studies argue, other providers

of credit should have increased their activity. Most

nonbank sources of credit to corporate businesses

have contracted during the 1990–91 recession.

From 1989 to 1991, not only did the annual flow

of funds from bank loans contract but so did the

flow of funds from finance companies, commercial

paper, mortgages, and trade credit. At the same

time, the flow of funds needed for capital expen-

ditures contracted sharply. These national


gate data are consistent with the hypothesis that

demand factors have driven the credit contraction.

In a comment on the Bernanke and Lown

study, Benjamin Friedman points out that they

assumed that other nonbank credit providers did

not suffer the same constraints (Bernanke and

Lown 1991). If loan losses have caused capital to

decline at banks, might not similar losses reduce

the capital of nonbank creditors, such as insurance

companies? Michael Keran (1992), vice president

and chief economist of the Prudential Insurance

Company of America, has acknowledged that

financial intermediaries other than banks have also

suffered declines in capital resulting from real

estate and other loan losses.

Because of their analytical approaches, both

of these empirical analyses have misdated the

beginning of the credit crunch. The Bernanke and

Lown analysis uses national data that mask impor-

tant differences among various regions of the

country. The Owens–Schreft analysis begins in

late 1989 and focuses on New England. Texas

suffered a severe contraction of its economy and

of bank credit during the last half of the 1980s

when the national economy was growing. By

failing to examine state-level data, both studies

misdate the start of the credit crunch by several

years and fail to establish its regional nature

(Rosenblum and Clair 1993).

Because Texas began its credit crunch earlier,

Texas is a better case study to examine long-term

effects. Texas’ banking industry was so severely

affected that even after the state’s economy began

a recovery in 1987, the banks did not increase

their lending. Even though Texas’ economy outper-

formed the nation’s during the 1990–91 recession

and experienced only a modest slowdown, lend-

ing at Texas banks did not increase for six years.

The life cycle of a credit crunch:

the Texas experience

Until 1987, Texas’ loan cycle was in line

with the regional economic cycle. During the

economic expansion of the first half of the 1980s,

loans extended by Texas banks more than doubled

from $52 billion in 1980 to $119 billion in 1985.

In the midst of continued growth in the national

economy, Texas entered a recession, triggered by a

precipitous decline in oil prices in 1986. Declines

in lending during an economic downturn are


The abnormality in the Texas lending pattern

surfaced about 1987. Despite an economic recovery,

lending continued to decline. From 1987 to 1990,

lending declined another 30 percent, even though

employment increased 6.8 percent. Even the

modest increase in loans outstanding that began

in 1992 does not reflect new lending as much as it

does acquisition of failed savings and loan associa-

Federal Reserve Bank of Dallas

crunch. A chain reaction of huge shocks to the

Texas economy resulted in the near destruction of

several key industries the state had relied on for

growth throughout the 1970s and 1980s. To

under-stand the Texas credit crunch, we must first

understand the nature of this abnormally strong

downturn and its repercussions on the economy.

In the late 1970s and early 1980s, the Texas

economy prospered as the oil and gas industry

boomed. Growth in the oil industry fostered

employment growth in all sectors of the Texas

economy. The climate was especially hospitable

for commercial real estate.3 Low vacancy rates,

changes in tax laws, and financial deregulation in

the early 1980s motivated investment in commer-

cial real estate.4 The state’s strong economy and a

drop in interest rates also encouraged the flow of

funds to the real estate sector (Petersen 1992). As

a result, office building permit values nearly

doubled from $1,143 million in 1980 to $2,184

million in 1985.

Even when an initial weakening of oil prices

in 1982 triggered a downturn in parts of the Texas

economy, commercial real estate activity continued.

Bankers’ and other investors’ interest in office

buildings persevered in the face of skyrocketing

vacancy rates. Office vacancy rates in major Texas

cities increased from 8 percent in 1980 to 24.3

percent in 1985, as office building permits con-

tinued to rise (Petersen 1992).

Texas was not so lucky after a second sharp

decline in oil prices in 1986. Recession struck the

state but not the nation. Texas is an oil-producing

state and an exporter of oil-field machinery, while

the nation is an oil importer. Reversals of the tax

laws that had favored commercial real estate

investments exacerbated the state’s economic

problems by accelerating the flow of funds out

of the office construction arena. The state lost

250,000 jobs and gained the burden of an extra-

ordinary amount of vacant office space. In 1987,

vacancy rates were near 30 percent in most major

Texas cities.

Unfortunately, the shocks engendering the

collapse of petroleum and construction were only

the beginning for Texas. Like other investors,

many aggressive banks were caught holding loans

to both oil and gas producers and commercial real

estate developers (Gunther 1989). Nonperforming

loan rates at Texas banks increased steadily from

1984 to 1987, and troubled assets caused declines in

equity capital and bank failures (Robinson 1990).

During the 1980s, equity capital at Texas

banks followed the same pattern as lending. From

1980 to 1985, equity capital increased by 85 per-

cent, or $6.2 billion. After the downturn in the

Texas economy, equity capital declined by 41 per-

cent, or $5.6 billion. The declines in equity capital

resulted from $10.8 billion in loan losses experi-

enced by Texas banks during the second half of

the 1980s.5 Although equity capital improved

somewhat in 1989 and 1990, it was 23 percent

below its peak.

3See Petersen (1992) for an excellent description of and

outlook for the Texas commercial real estate industry.

4Petersen (1992) explains that the Economic Recovery Tax

Act of 1981 redefined the business depreciation allowance

for some real estate properties to allow for an accelerated

recovery of investments, thus making those investments

more attractive. For an extended discussion of the effects of

depreciation rates on real estate decisions, see Yeats

(1989). Also, the Depository Institutions Deregulation and

Monetary Control Act of 1980, which helped phase out

interest rate ceilings on time and savings deposits, and the

Garn–St Germain Depository Institution Act of 1982, which

created the money market deposit account, resulted in a

large source of new funds. The Garn–St Germain Act further

liberalized investments that S&Ls could make (although

Texas state-chartered S&Ls already had these powers) and

included provisions for the creation of nonexistent capital

through the issuance of capital certificates. Together, these

changes provided tremendous incentives favoring invest-

ment in commercial real estate.

5When loans are charged off as losses, these losses are

deducted from the allowance for loan loss (a reserve

account on the balance sheet), which historically was

considered a part of regulatory capital. If the charge-offs

are large, then the allowance must be replenished be-

cause the adequacy of the allowance is judged relative

to the size of the loan portfolio and its risk. This is done by

Economic Review — Third Quarter 1993

For many banks, the decline in bank capital

was fatal. Bank failures skyrocketed to levels not

seen since the Great Depression. No Texas banks

failed in 1981, but thirty-seven did in 1986, and

the numbers kept climbing.6 Texas bank failures

peaked in 1988 at 149 and were down to 31 in

1992. The savings and loan industry suffered an

even higher failure rate.

Pathology of a credit crunch

Researchers at the Federal Reserve Bank of

Dallas have examined the connection between

financial health of banks and their lending activity

and have found that during the latter half of the

1980s, many Texas banks were too unhealthy to

lend. Financially unhealthy banks are those with

capital-asset ratios below 6 percent, with negative

income, or with a troubled-asset ratio of 3 percent

or more. In 1986, 55 percent of Texas banks

holding 72 percent of the state’s total banking

assets were unhealthy by this standard. Increased

lending by these banks would have exposed them

to unacceptable risk of failure. Lending would

have been discouraged or prohibited by bank

supervisors and, in all likelihood, by the banks’

own boards of directors.

Since the second quarter of 1988, the health

of the state’s banking industry has steadily im-

proved. By the fourth quarter of 1992, 72 percent

of Texas banks, with 82 percent of the state’s

assets, were healthy (Table 1). The improvement

resulted from the failure of many unhealthy banks,

from customers’ switching their business from

unhealthy banks to healthy banks, and the finan-

cial recovery of some unhealthy banks. However,

Category: Credit

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