Banking and the Determinants of Credit Crunches

Why do banks suddenly tighten the criteria needed for credit? Credit crunches are often explained by the implementation of new regulatory rules or by sudden drops in firm quality. We present a novel model of an artificial credit market and show that crunches have a tendency to occur even if firm quality remains constant, as well as when there are no new regulatory rules stipulating lenders capital requirements. We find evidence in line with the asset deterioration hypothesis and results that emphasise the importance of accurate firm quality estimates. In addition, we find that an increase in the debts’ time to maturity reduces the probability of a credit crunch and that a conservative lending approach is intrinsically related to the onset of crunches. Thus, our results suggest some up till now partially overlooked components contributing to the financial stability of an economy.