The Credit Crunch

How the economy functions(and why we rely on credit)

Learning Objectives

At the end of this lesson, you should know:• How banks fit into the economy• Why banks stop lending• Definition of a ‘credit crunch’• How a credit crunch effects ordinary

people

Key terms you need to know

• DEPOSITOR: Someone who hands their cash over to a bank for safe keeping.

• LOAN: A sum of money that is lent, and repaid with interest.

• MORTGAGE: a loan from a bank to fund the purchase of a house or flat.

• CREDIT: Money (or the promise of money) loaned to people or businesses that need it.

How banks work

MEGABANK

Ordinary people deposit their savings

Depositor

Personal borrowers(eg taking a mortgage to

buy a house)

Banks borrow money and lend it to people and

businesses who will repay these loans with interest

Other banksBusiness borrowers

(eg taking a loan to build a new factory)

Other banks lend money

Banks cannot lend more money than they have (or can borrow)

MEGABANK

ASSETSDepositors cash

+ Loans from other banks+ Shareholder funds

LIABILITIESBusiness loans+ Mortgages

+ Personal loans

CANNOT BE LESS THAN> >

Why banks stop lending

MEGABANK

And unemployed people may find it hard to repay

their mortgages

If businesses and people start to loose money, and can’t repay their loans, then the bank will have less cash.

The bank will have less money to loan out.

But businesses can shrink and sack workers

Normally, loans are repaid bit by bit every month

If loans go bad the bank may loose depositors and lenders ...

MEGABANK

If a bank looks like it cannot pay back money,

then the people and banks that have

DEPOSITED money may withdraw.

This is called arun on the bank.

People withdraw their savings

Other banks try to withdraw loans

... And quickly go bust!

ASSETSFewer deposits

+ Funds from other banks withdrawn

LIABILITIESIncreased by bad debts (borrowers who won’t

repay)

MEGABANK

What is a credit crunch

• Many of the banks around the world lend to each other every day, and have long-term investments in other banks

• SO, if one bank reduces lending (and keeps the cash to itself), then all the others will reduce lending

• The CREDIT CRUNCH is a result of every banks reducing lending at the same time, and means that no one is able to borrow money easily

The Credit Crunch in action

MEGABANK

Depositor

People are unable to get a mortgage and so

cannot buy a house

Other banksBusinesses are unable

to invest in new factories or services

People stop depositing money

Banks stop lending to each other

Megabank will try to preserve what cash it has by stopping lending

How will the credit crunch effect you and me

• Some of the ways the credit crunch may effect ordinary people:– Moving house: mortgages are harder to arrange,

and so buying a new house takes longer– Starting a new business: more difficult to get the

investment needed– Personal loans: more expensive to get a new car– Jobs: businesses try to save money by firing

workers or stopping hiring new employees

Where do banks get their money?

All of the above

From businesses repaying their loans

From stockmarket investors

From other banks

From individuals with savings accounts

Why do banks lend money?

All of the above

Because the law says they must

Because they need to give it away

So that the bankers have a job to do

So that they can earn interest on the loans

What happens in a ‘credit crunch’?

All of the above

People find it difficult to borrow from any bank

There is an increase in car crashes

Banks start lending money for free

There are lots of earthquakes around the world

Put the statements in the right columnBanking as Usual During a Credit Crunch

People with a steady job and a deposit can get a mortgage

Even people with good jobs and a large deposit may not get a mortgage

Banks can get extra money by borrowing from other banks

Any bank will find it difficult and expensive to borrow extra money

Established, profitable businesses can get cheap loans

Profitable businesses can only get bank loans at high interest rates