Credit Card Guide

What Is Credit Crunch?

30 November 2012 by CreditCardsCo™

The economy is cyclic so there will always be high and low periods. During a recession, banks tighten their grip on credit, which causes a "credit crunch." This makes it more difficult for consumers to get the credit they might need. This includes home loans, credit cards, and auto loans.

During a recession, there is usually a period where banks start to exercise restraint on their lending. When this period extends it is known as a "credit crunch" and it can be a very difficult time for many people. If the period continues the economy goes into an official depression because money becomes devalued.

Right now, the American economy is struggling, and this means that it will become more and more difficult to use credit in the coming years. Part of this has to do with tighter credit laws that help to improve the function and security of credit.

Credit Crunch: Defined

A credit crunch occurs when there is a general reduction in the availability of funds for credit or when there is a sudden tightening of regulations by banks who issue credit, such as loans and other financial products. This often also results in lenders and investors pulling their money out of riskier investments and placing them into ones with more stability, which then sometimes creates a domino effect which puts smaller enterprises at risk because they have less investment capital.

A credit crunch is often considered to be an extension of a recession. By definition, the economy must be downswing in order for a credit crunch to occur, so it is only natural that a recession should occur first. If the economy can make it out of a credit crunch, then the banks will be rejuvenated again.

Credit Crunch: The Cause

There are many reasons why banks could stop or slow their lending practices.

  • After a period of careless or inappropriate lending, financial institutions do not see return on their investments or their debts go bad and these banks need to recoup losses
  • Anticipated decline in the value of all collateral: inflation causes money to devalue, home prices plummet, etc
  • A somewhat inexplicable change in monetary conditions: the FED unexpectedly raises or alters Federal Reserve requirements or imposes new regulatory controls or restraints on lending in general
  • Governmental impositions on the entire banking system
  • Increased industry perception regarding the risks associated with solvency of intermediary banks within the banking system

Any one of these reasons, among others, and singularly or in combination, could result in a credit crunch. However, these things usually first result in a reduction of market prices of assets that had been previously overinflated; basically, there is a price collapse and then a pending market failure which causes the credit crunch.

Credit Crunch: The Aftermath

During a credit crunch, companies need to find ways to either generate more profits or liquidate their assets in order to cushion the pending losses. While consumers may not be aware that the crunch is coming, simply because preparation for one often only comes after receiving inside information, there are signs that banks are getting ready to tighten their leash:

  • Frenzied or competitive, leveraged asset bidding which causes the inflation of that asset. This leads to a price bubble, which usually bursts and causes the crisis.
  • New debt upswing increases money supply which stimulates economic activity including industrial and employment growth
  • An increase in "loose credit," cheap, plentiful, easy lending practices that often saturates the market with overextended or otherwise undeserving loan (as was the case with the Clinton housing initiative)

Conclusion

These are all signs that are part of the cyclic economy. There will always be highs and lows, but when several variables are in place and working together, it can be obvious to the trained observer when the eventual decline will occur.

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