WHAT IS Financing Squeeze
A financing squeeze is when would-be borrowers find it difficult to obtain capital because lenders fear making loans. This often leads to a liquidity crisis if there is little cash on hand and not enough operating cash flow.
A financing squeeze also occurs if credit is available, but only at a price that is unaffordable for most potential borrowers, or in rare situations when government intervention artificially lowers the cost of capital, but banks still maintain high lending standards. This makes it very difficult for most to attain capital. A severe financing squeeze broadly felt by many in the U.S. preceded the Great Recession of 2007-2009.
BREAKING DOWN Financing Squeeze
A financing squeeze, also known as a credit crunch, happens most often amid increased lending risk, meaning marketing conditions make it likely that many borrowers will default on their loans. When this happens, the loan market tends to dry up, as governments force banks to hold more money in their reserves in an effort to prevent possible bank failures. This makes less funding available for banks to lend. Severe credit crunches faced by many is the result of systemic risk.
A financing squeeze is not limited to large corporations. The term applies to small businesses individuals and even municipalities. All four tend to face a higher likelihood of a financing squeeze in periods of tight lending conditions and when their balance sheets are weak.
Financing squeezes also result from credit risk, or particular situations only faced by a company or individual. For example, a marketing director at a large company loses her job, cannot find another quickly and doesn’t have much money saved. Without a loan, perhaps from a family member, she could face bankruptcy.
In another example, an oil exploration and production company drills a dry hole, for which it now expects next to no return. It paid for the drilling project with a bank loan, and does not have sufficient cash on hand or cash flows pay back the bank. This makes it very hard for the energy company to secure another loan to start another well, as many lenders now consider the firm overleveraged.
Impact of Financing Squeeze
As with the case with the oil & exploration company, a financing squeeze often results in a poor credit rating, making it difficult to secure loans in the future. Companies can still get loans, but only at a far-higher cost of capital. This affects future projects, raising the total cost of completing them, and making a larger number of them unattractive. As a result, a financing squeeze can turn a project that otherwise would have a positive net asset value into an unprofitable venture.
When many companies and individuals face a financing squeeze at roughly the same time due to market conditions, this often leads to recession.