Credit Crunch

A credit crunch is an economic condition in which investment capital is hard to secure. Banks and investors become wary of lending funds to individuals and corporations, which drives up the price of debt products for borrowers. 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.

Sometimes called a credit squeeze or credit crisis, a credit crunch tends to occur independent of a sudden change in interest rates. Individuals and businesses that could formerly obtain loans to finance major purchases or expand operations suddenly find themselves unable to acquire such funds. The ensuing ripple effect can be felt throughout the entire economy, as homeownership rates drop and businesses are forced to cut back due to a dearth of capital.

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.

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 take away from individuals' ability to spend money in the economy, and it eats into business capital that could otherwise be used to grow operations and hire workers.

For some businesses and consumers, the effects of a credit crunch are worse than and increase in the cost of capital. Businesses unable to borrow funds at all face trouble growing or expanding, and for some, remaining in business becomes a challenge. As businesses scale back operations and trim their workforces, productivity declines and unemployment rises, two leading indicators of a worsening recession.