A credit crunch occurs when there is a lack of funds available in the credit market, making it difficult for borrowers to obtain financing. This happens when lenders have limited funds available to lend (or are unwilling to lend additional funds), or have increased the cost of borrowing to a rate that is unaffordable to most borrowers.

Let's take a look at the anatomy of a credit crunch.

When lending institutions have suffered losses from previous loans, they are generally unwilling or unable to lend. This occurs when borrowers default and the properties underlying a defaulted loan decline in value. In this situation, as borrowers default, banks foreclose on the mortgages and attempt to sell these properties to regain the funds they loaned out. Consequently, if home prices fall, the bank is left selling at a loss. Because banks are required to retain minimum levels of liquidity (capital), when they suffer losses, their capital positions are reduced, which reduces the amount they are able to lend out.

Credit crunches can also occur when regulatory bodies increase capital requirements for financial institutions. Banks and other lenders are required to maintain a set amount of capital liquidity based on their risk-weighted level of assets. If this requirement increases, many banks will need to increase capital reserves. To comply, banks will cut lending, reducing the availability of loans for individuals and companies.

Also, if banks perceive a greater risk in the market, they will often raise their lending rates to offset this risk. This increases the cost of borrowing and makes it more difficult for borrowers to access financing. If borrowers aren't willing to borrow at these rates, the bank is unlikely to lend at all.

Overall, a credit crunch can do a lot of damage to the economy by stifling economic growth through decreased capital liquidity and the reduced ability to borrow. Many companies need to borrow money from lending institutions to finance and/or expand operations; without this ability, expansion is not possible and in some cases, companies will need to cease operations. When coupled with a recession, a credit crunch can often lead to many corporate bankruptcies. This increases the crunch's economic impact by stifling the economy's ability to recover.

For related reading, see How Will Your Mortgage Rate?

(For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.)

  1. What are the risks of annuities in a recession?

    Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
  2. How does the risk of investing in the industrial sector compare to the broader market?

    There is increased risk when investing in the industrial sector compared to the broader market due to high debt loads and ... Read Full Answer >>
  3. How can I hedge my portfolio to protect from a decline in the retail sector?

    The retail sector provides growth investors with a great opportunity for better-than-average gains during periods of market ... Read Full Answer >>
  4. What is the correlation between term structure of interest rates and recessions?

    There is no question that interest rates have enormous macroeconomic importance. Many economists and analysts believe the ... Read Full Answer >>
  5. Why should an investor in the retail sector consider the Consumer Confidence Index?

    Investors in the retail sector should consider the Consumer Confidence Index, or CCI, because it measures how consumers feel ... Read Full Answer >>
  6. Which type of retailers tend to perform best during weak periods in the economy?

    Retail is a broad investment sector comprising many different market segments, such as automotive, building supply, grocery ... Read Full Answer >>
Related Articles
  1. Insurance

    What is a Force Majeure?

    A force majeure clause frees both parties in a contract from fulfilling their obligations in the event of some catastrophic or unexpected occurrence.
  2. Credit & Loans

    Explaining Equated Monthly Installments

    An equated monthly installment is a fixed payment a borrower makes to a lender on the same date of each month.
  3. Professionals

    10 Must Watch Documentaries For Finance Professionals

    Find out about some of the best documentaries that finance professionals can watch to gain a better understanding of their industry.
  4. Investing Basics

    Tiny House Movement: Making Market Opportunities

    The tiny house movement throws all assumptions about household budgeting and mortgage management out the window, and creates new market segments too.
  5. Investing

    Where Should I Keep My Down Payment Savings?

    While saving up for a down payment, where should you keep your money. A bank? The stock market? It all depends on your timeline.
  6. Credit & Loans

    Questions To Ask Your Mortgage Lender

    When buying a house, avoid nasty surprises by asking the right questions about your mortgage lender's qualifications and the mortgage process.
  7. Markets

    Is Another Bear Market Ahead?

    With market volatility recently reaching its highest level, investors are questioning what the outlook is for U.S. stocks in 2015 and beyond.
  8. Stock Analysis

    Why Is GE Selling Some of Its Subsidiaries?

    Learn why GE is selling off a substantial amount so it does not have to comply with increased government regulation in the wake of the 2008 financial crisis.
  9. Credit & Loans

    Bad Credit? You Can Still Get a Home Equity Loan

    If your credit history is less than stellar and you need cash, you may be able to get financing – but it will come at a price.
  10. Home & Auto

    5 Ways to Pay Down Your Mortgage - Without Going Broke

    Following these tips can help you reduce the length of your mortgage and save you thousands of dollars.
  1. Encumbrance

    A claim against a property by a party that is not the owner. ...
  2. Equity

    Equity is the value of an asset less the value of all liabilities ...
  3. Chattel Mortgage Non-Filing Insurance

    An insurance policy covering losses that result from a policyholder ...
  4. Zombie Foreclosure

    A situation (or a home in this situation) that occurs when a ...
  5. Regional Asset Liquidation Agreement (RALA)

    An agreement between an asset manager and the Federal Deposit ...
  6. The New Deal

    A series of domestic programs designed to help the United States ...

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!