Credit Crunch
A credit crunch refers to a decline in lending activity by financial institutions brought on by a sudden shortage of funds. Sometimes called a credit squeeze or credit crisis, a credit crunch tends to occur independently of a sudden change in interest rates. A credit crunch often follows a period in which lenders are overly lenient in offering credit and results in higher rates as a way to compensate the lender for taking on the additional risk. In addition to tightening credit standards, lenders may increase interest rates during a credit crunch to earn greater revenues from the reduced number of customers who are able to borrow. Often an extension of a recession, a credit crunch makes it nearly impossible for companies to borrow because lenders are scared of bankruptcies or defaults, resulting in higher rates.
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What Is a Credit Crunch?
A credit crunch refers to a decline in lending activity by financial institutions brought on by a sudden shortage of funds. Often an extension of a recession, a credit crunch makes it nearly impossible for companies to borrow because lenders are scared of bankruptcies or defaults, resulting in higher rates.
Understanding a Credit Crunch
A credit crunch is an economic condition in which investment capital is hard to secure. Banks and other traditional financial institutions become wary of lending funds to individuals and corporations as they are afraid that the borrowers will default. This causes interest rates to rise as a way to compensate the lender for taking on the additional risk.
Credit Crunch Causes
A credit crunch often follows a period in which lenders are overly lenient in offering credit. Loans are advanced to borrowers with questionable ability to repay, and, as a result, the default rate and presence of bad debt begin to rise. In extreme cases, such as the 2008 financial crisis, the rate of bad debt becomes so high that many banks become insolvent and must shut their doors or rely on a government bailout to continue.
The fallout from such a crisis can cause the pendulum to swing in the opposite direction. Fearful of getting burned again by defaults, banks curtail lending activity and seek out only borrowers with pristine credit who present the lowest possible risk. Such behavior by lenders is known as a flight to quality.
Credit Crunch Consequences
The usual consequence of a credit crunch is a prolonged recession, or slower recovery, which occurs as a result of the shrinking credit supply.
In addition to tightening credit standards, lenders may increase interest rates during a credit crunch to earn greater revenues from the reduced number of customers who are able to borrow. Increased borrowing costs hinder an individual's ability to spend money in the economy, and it eats into business capital that could otherwise be used to grow operations and hire workers.
Related terms:
Bankruptcy
Bankruptcy is a legal proceeding for people or businesses that are unable to repay their outstanding debts. read more
Cost of Capital : Formula & Calculation
Cost of capital is the required return a company needs in order to make a capital budgeting project, such as building a new factory, worthwhile. read more
Credit
Credit is a contractual agreement in which a borrower receives something of value immediately and agrees to pay for it later, usually with interest. read more
Default
A default happens when a borrower fails to repay a portion or all of a debt, including interest or principal. read more
Depression
An economic depression is a steep and sustained drop in economic activity featuring high unemployment and negative GDP growth. read more
Financial Crisis
A financial crisis is a situation where the value of assets drop rapidly and is often triggered by a panic or a run on banks. read more
Flight to Quality
Flight to quality is the action of investors moving their capital away from riskier investments to safer ones. read more
Interest Rate , Formula, & Calculation
The interest rate is the amount lenders charge borrowers and is a percentage of the principal. It is also the amount earned from deposit accounts. read more