Is the credit crunch a supply side phenomenon? A theoretical appraisal

This paper provides a theoretical understanding of the credit crunch in general and the current crisis in particular. It is still an open question: Does the reduction in equilibrium loan amount result from supply side factors, or is it driven by weak loan demand? I use a simple micro theoretical model with an uncertain loan customer and an imperfectly competitive bank (with some market power) to explain the current credit situations. The direction of the interest rate is critical in determining whether the credit decline is a consequence of a precipitous drop in loan demand exacerbated by current weakness in the economy or is it due to simple loan reduction by the lending institutions. Comparative static results shows effects of the collateral (borrower), capital adequacy standards of depository institutions, and economic conditions on the loan amount. The link between economic conditions and the loan amount is shown as positive. The connection between collateral and the loan amount is not clear due to presence of limited liabilities and moral hazard. These moral hazard problems may lead to credit rationing by generating a non-monotonic relationship between quoted interest rates and expected rates of return as in the Stiglitz-Weiss model. However, under restrictive conditions the tie between collateral and loan amount is positive.