What is a Credit Crunch?

Credit crunch or credit crisis refers to a reduction in the availability of credit. Sometimes, it is characterized by a sudden change in credit policies, whereby, stiffer conditions are imposed in regard to obtaining loans from the banks. When such a condition occurs, the small and the medium sized entrepreneurs are the worst hit lot. With lending institutions, as well as investors opting for less risky investment options, while the small and medium sized enterprises are clearly left to fend for themselves. Most times, we see a sharp decline in availability of credit, often diminishing the relationship between credit availability and interest rates.

It is not known, as to who coined the term credit crunch, for the very first time. However, it is extensively used to describe a situation, where credit is not readily available and investment capital is difficult to obtain. A credit crunch is marked by banks and financial institutions becoming wary of extending loans to corporations. This results in huge amounts of debt products for borrowers. The sub prime mortgage crisis is a recent example of credit crunch, featuring contracted credit availability in global markets and banking systems. The main reason for this situation was attributed to the failure of mortgage companies, investment firms, as well as government-sponsored enterprises.

Several reasons are attributed to the situation called credit crunch. Most of the times, such a situation, has been said to be a direct result of huge bad debts. In order to keep up with the competition, most lending institutions lower their criteria for credit. This leads to many inappropriate debts, as a result of which, credit crunch occurs. Although this is not the only reason; but definitely it is one of the most common reasons.

Another reason for this might be anticipation in regard to fiscal, as well as monetary regulations. As a result of this anticipation, most lending institutions feel wary of extending credit to corporate, especially small and medium sized firms. Several monetary policies, such as change in interest rates as well as changing the reserve requirements are responsible in a big way.

Reduction in the market prices of overinflated value of assets, results in losses. As a result, there arises a situation, where we have foreclosures and bankruptcy mainly for those who entered the market pretty late.

A major impact of credit crunch is that, it affects not only borrowers and lending institutions, but also the financial scenario and the economy as a whole. As interest rates go up, it puts a brake on new investments and consumer demands, as a result of which, there is a slowdown in the economic growth. Lack of credit forces reconsideration of new deals. With the entire economy being affected, even sound borrowers may default due to sudden demand for repayment. This further causes panic and deteriorates the situation.