Business, Legal & Accounting Glossary
The credit crunch is the informal term for the decrease in lending activity that has made business more difficult for companies reliant upon leverage, or borrowed capital.
A credit crunch (or credit crisis) is an economic condition in which loans and credits for investment are suddenly unavailable. This can also represent the unavailability of credit due to the increase in the cost of loans provided by the banks and other financial institutions in an environment in which large losses and asset value write-downs are taking place.
A credit crunch leads to the increase in the interest rates which make it further impossible for the borrowers to secure credit. Banks and creditors cautiously disburse funds to the corporations, fearing bankruptcies and defaults in payments by the borrower. A credit crunch is a product of a recession or negative financial environment. The shrunk credit supply during such a crunch leads to a prolonged recession in the economy.
There are various reasons as to why there is a credit crunch. Most often a major cause of credit crunch is a long period of faulty and injudicious practices on the part of lenders. However, there are other causes that are just as important.
Reduction in prices of goods or assets in a particular market can also result in a credit crunch. In this case prices of assets, that had been previously overinflated, go down and this results in a credit crunch. Excessive leverage in borrowing against assets that had previously been going up in value further exacerbates the situation.
A credit crunch is a sudden reduction in the availability of loans (or “credit”) or a sudden increase in the cost of obtaining a loan from the banks. There are a number of reasons why banks may suddenly increase the costs of borrowing or make borrowing more difficult. This may be due to an anticipated decline in value of the collateral used by the banks when issuing loans, or even an increased perception of risk regarding the solvency of other banks within the banking system. It may be due to a change in monetary conditions (for example, where the central bank suddenly and unexpectedly raises interest rates or reserve requirements) or even may be due to the central government imposing direct credit controls or instructing the banks not to engage in further lending activity.
A credit crunch happens when banks are reluctant to loan money to individuals and businesses. In a credit crunch situation, it becomes increasingly difficult for companies to obtain funding. When and if lenders do offer loans during a credit crunch, they do so at relatively higher interest rates, which can be prohibitively expensive. Several situations can lead to a credit crunch. When banks, in unison, are concerned about elevated counterparty risk (i.e. high rates of defaults, bankruptcy, etc.), a credit crunch can ensue. Also, if banks find themselves overexposed in an economic downturn (i.e. subprime mortgages crisis), many banks may have to reduce loan availability in order to not aggravate their collateral shortfall, resulting in a credit crunch. A credit crunch has significant consequences on the economy. A credit crunch can tighten the flow of capital causing businesses to lay off employees or shut down completely due to their inability to borrow capital. A credit crunch is also referred to as a credit squeeze.
It is often caused by a sustained period of lax and inappropriate lending which results in losses for lending institutions and investors in debt when the loans turn sour and the full extent of bad debts becomes known. These institutions may then reduce the availability of credit, and increase the cost of accessing credit by raising interest rates. In some cases, lenders may be unable to lend further, even if they wish, as a result of earlier losses restraining their ability to lend.
A credit crunch is generally caused by a reduction in the market prices of previously “overinflated” assets and refers to the financial crisis that results from the price collapse. In contrast, a liquidity crisis is triggered when an otherwise sound business finds itself temporarily incapable of accessing the bridge finance it needs to expand its business or smooth its cash flow payments. In this case, accessing additional credit lines and “trading through” the crisis can allow the business to navigate its way through the problem and ensure its continued solvency and viability. It is often difficult to know, in the midst of a crisis, whether distressed businesses are experiencing a crisis of solvency or a temporary liquidity crisis.
In the case of a credit crunch, it may be preferable to “mark to market” – and if necessary, sell or go into liquidation if the capital of the business affected is insufficient to survive the post-boom phase of the credit cycle. In the case of a liquidity crisis, on the other hand, it may be preferable to attempt to access additional lines of credit, as opportunities for growth may exist once the liquidity crisis is overcome.
A prolonged credit crunch is the opposite of cheap, easy and plentiful lending practices (sometimes referred to as “easy money” or “loose credit”). During the upward phase in the credit cycle, asset prices may experience bouts of frenzied competitive, leveraged bidding, inducing hyperinflation in a particular asset market. This can then cause a speculative price “bubble” to develop. As this upswing in new debt creation also increases the money supply and stimulates economic activity, this also tends to temporarily raise economic growth and employment.
Often it is only in retrospect that participants in an economic bubble realize that the point of collapse was obvious. In this respect, economic bubbles can have dynamic characteristics, not unlike Ponzi schemes or Pyramid schemes.
As prominent Cambridge economist John Maynard Keynes observed in 1931 during the Great Depression: “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.”
The 2007 subprime mortgage financial crisis is considered by some to have caused a credit crunch.
A Credit crunch is different from a liquidity crisis. Liquidity crises happen when an economically-sound business enterprise is unable to generate bridge finance that is required in order to operate or expand the business.
Sometimes governments impose restrictions on lending in the form of raising rates or adopting other monetary practices for consumers and businesses. This leads to a credit crunch, also known as a credit squeeze.
There are certain strategies that may be adopted by a business enterprise when it faces a credit crunch, including:
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This glossary post was last updated: 4th August, 2021 | 8 Views.