What Is a Credit Crunch? Definition, Causes, Examples and Effects

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.

Sometimes called a credit squeeze or credit crisis, a credit crunch tends to occur independently 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 home-ownership rates drop and businesses are forced to cut back due to a dearth of capital.

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.

For some businesses and consumers, the effects of a credit crunch are worse than an 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 workforce, productivity declines and unemployment rises, two leading indicators of a worsening recession.