What is... | April 10, 2013

What is a credit crunch?

In the aftermath of the global financial crisis, it seemed difficult to get through the day without hearing “credit crunch". Put simply, the term refers to particular difficulties getting loans. And while talk of the credit crunch diminished over several years as the recovery started to take hold, it remains a relevant term in the world of finance.

After all, the credit crunch described above is only one of several throughout history – and it could well happen again.

It’s more difficult to borrow
When interest rates are very low, as they were in many countries after the 2007 financial crisis, it can be a cheap time to borrow money. However, it can also be difficult to get a bank or other financial institution to lend. Obstacles may be in place that weren’t there in the past. Checks on borrowers’ eligibility for a loan may be more difficult to pass or the amount offered for borrowing may be less. The squeeze on the availability of credit becomes a “credit crunch” when lenders continue to be cautious even after the worst of the crisis had passed. Research suggests that recessions with credit crunches may tend to be deeper and longer than those without.

When lenders have reduced appetite for risk…
It is usually difficult to borrow money when economic growth is slow because lenders may be less sure that they will get their money back. In normal circumstances, a return to growth would allow lenders to again take more risk and be more prepared to lend money. A credit crunch differs from this normal pattern because financial institutions continue to be cautious even after the worst of a slowdown has passed and growth has started to improve.
There may be several reasons a credit crunch happening. Sometimes the financial health of banks may have been severely damaged and they do not have the capacity to lend as readily as in the past. Changes in government regulations around lending may also play a role. Arguably as important can be a reduction in the animal spirits of the people who run banks so that they are less prepared to take the risk of lending money.

We cut back on luxuries
A credit crunch can have dramatic effects on an individual’s or a company’s financial situation. Before the crunch, many forms of finance are relatively easy to access – think ready availability of mortgages, car loans and credit to buy expensive equipment. During a credit crunch, official interest rates set by central banks can be low making borrowing attractive but money can still be hard to come by as lenders may be more risk averse and make their application processes more stringent.
In the home, that might mean people cut back on luxuries (as was the case in Korea after 1997), postpone moving house if mortgages are unavailable or put off other major life changes. Business owners can also face difficulties that can have wider spin-offs, such as the argument here that shop closures on British high streets have social implications.

Seeking alternatives?
Check the fine print One consequence of a credit crunch is that people may turn to alternative lenders – and these alternatives might carry extra costs or conditions. Examples include pay day loans (usually borrowing small amounts for very short time periods but at much higher interest rates) or relying on a credit card as finance. These sources might suit some individuals but remember that circumstances vary. It can be crucial to read the fine print and be wise to the costs. Calculate the annual percentage rate (apr) to compare the costs of different loans.

Do you have a “rainy day” fund?
A credit crunch can end up being a financial emergency for some. It demonstrates the importance of building an emergency fund of three-to-six months of pay to use when circumstances take a difficult turn. The emergency fund – or “rainy day” fund, as they are sometimes called – can come in handy rather than turning to alternative credit lines that charge high interest.

eZonomics team
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