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Credit Crisis – Causes, Effects And How To Manage Credit Crisis

Credit Crisis

Credit Crisis, also called Credit Crunch, has affected a lot of people around the globe as well as various economies. Despite it being a major cause of alarm, most people are still oblivious as to what it really means, as well as the major consequences.

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Investopedia explains Credit Crisis as one that occurs when several financial institutions issue or are sold high-risk loans that start to default; and as borrowers default on these loans, the financial institutions that gave out or issued these loans stop receiving payments. A credit crisis is a period where there is a distinct and harsh reduction in the availability of loans from financial institutions or a tightening of conditions required to obtain a loan from banking institutions.

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A credit crisis usually leads to foreclosure and bankruptcy for investors. This crisis is caused mostly by reckless lending for a long amount of time by lending institutions leading eventually to huge amounts of losses and investors in debts when these loans go bad.

A sudden reduction in the market prices of previously inflated assets could also be the cause of a credit crunch. When lending institutions have inadequate or incorrect information about the financial strength of the borrowers and eventually discover that borrowers are incapable of paying the loans already issued, a credit crunch might result.

Another cause of a credit crisis could be when the Central Bank unexpectedly raises the reserve requirements or imposes a new form of regulatory constraints on lending.

The financial crisis of 2007-2008 also known as the global financial crisis that rocked the world (dare I say it is still rocking the world!), is an example of the effect of the Credit Crisis. It threatened the collapse of various financial institutions and even led to the fall of some major ones. The global recession which was the most severe event since the Great Depression was a result of the collapse of the mortgage system in the United States despite several warnings by financial analysts in preceding periods.

During this period, many investment firms in many countries had invested in the United States mortgage industry through stock exchange listed companies and there was a rise in the issuance of high-risk loans to clients who either had poor credit histories or none at all. Huge amounts of capital were injected into the real estate market after all it was the ongoing trend at the time and this made the values of houses go higher. As interest rates started to go higher, the clients found it more and more difficult to pay back the loans they had borrowed, leading to the failure of banks like Lehman Brothers, Merril Lynch being bought by the Bank of America, and some other financial institutions facing bankruptcy. The collapse sent a spiral doom effect to several countries and even led to the free fall of the dollar currency.

The credit crisis led to:

  • Slow economic growth
  • Increase in unemployment
  • The collapse of various financial institutions
  • Lack of confidence in the banking system and financial markets
  • Growing budget deficits
  • Lack of adequate cash flows
  • The decline in the remittances to developing countries
  • Reduced access to credit
  • The collapse of the housing markets

In Nigeria, banks became vulnerable because of their over reliance on foreign institutions for credit lines.

Episodes of fuel scarcity in Nigeria can be attributed to the credit crisis. This is because major marketers usually have access to credit by opening a line of credit that the Central Bank of Nigeria vouches for. This in recent times hasn’t been as seamless as it used to be.  The pressure on the exchange rate, capital market downturn, limited foreign trade finances for banks, and fall in export revenues, as well as the depletion of foreign reserves, are all possible outcomes of a credit crisis.

Even though credit crises are inevitable, it does not mean that their effects or impacts cannot be managed. A reduction in risk appetite, proper and improved accountability by lending institutions, a reduction in excessive lending, regulation of foreign reserves, promotion of intra-African trade (in the case of that continent), healthy mergers between financial institutions would go a long way in reducing the effects of the credit crisis on an economy.

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