What happens during a ‘credit crunch’ and how to prepare for it

The recent banking crisis has fueled concerns about a “credit crunch” and the ensuing negative impact on households, businesses and the US economy.

But what is a credit crunch and how do you prepare?

During a credit crisis, banks tighten their credit conditions considerably.

Loans are getting harder to get. Banks that offer them may do so with harsher terms, such as high interest rates or other restrictions, making such financing more expensive.

In general, for example, it becomes more difficult for households to buy cars and houses or repair their roofs, and for companies to rent, expand and open new shops or factories. Cooling bank lending spills over into the economy’s profits, making a recession more likely.

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“Credit is the mother’s milk of economic activity,” said Mark Zandi, chief economist at Moody’s Analytics.

“I would be surprised if we don’t see a fairly significant tightening of credit in small and medium-sized banks in the near term,” he added.

Of course, there must be a happy medium in a well-functioning economy, Zandi said.

Leaning standards that are too loose can also be detrimental. During the financial crisis, for example, massive subprime mortgages issued by banks caused a housing crisis that ultimately led to a deep recession.

A credit crunch seems likely given the banking problems that have unfolded over the past two weeks.

Silicon Valley Bank and Signature Bank failed as depositors rushed to withdraw their money and the banks were unable to meet demand for cash.

Banks do not keep all customer cash on hand. They make money from those deposits by investing or lending (and receiving interest payments) a portion of the money.

One of the SVB’s problems was investing in long-dated US government bonds. SVB locked billions of dollars into these bonds, which lost money when the Federal Reserve began aggressively raising interest rates last year to combat high inflation.

What this all means: To avoid a similar fate, many banks will likely prioritize strengthening their balance sheets to weather a potential bank run, experts say.

Banks could limit lending to, for example, have more cash on hand to meet customer repayments. In addition, if bank customers withdraw money, a bank may have a smaller supply to make loans.

“You’re going to see a credit crunch happen in the US, and that’s starting to be priced into the market in a dramatic way,” Mike Novogratz, CEO of Galaxy Digital, an investment management firm, said in an interview with CNBC’s “Squawk Box” last week.

However, a serious credit crisis is not a foregone conclusion.

The extent of the banking contagion remains unclear, Zandi said. The country’s largest banks are also unlikely to significantly change their lending behavior, he added.

Banks had reduced the flow of credit to businesses and households even before the recent chaos.

In the fourth quarter, banks reported tightening their standards for credit cards, home equity lines of credit, auto loans and other consumer loans, according to the Federal Reserve’s latest Senior Loan Officer Opinion Survey. For example, they reported an increase in the minimum credit scores required to secure such loans.

A significant portion also tightened standards for commercial and industrial lending to businesses, the survey said.

“I think a lot of banks would of course look at potential [tighten standards] concerns about a recession, even without these banking issues that have come to the fore recently,” said Christine Benz, director of personal finance at Morningstar.

There are some steps consumers can take now to prepare for a potential credit crunch.

If you have an imminent credit need, make sure your credit rating is “as attractive as possible,” Benz said.

That may include making sure you pay credit card bills and other debt payments in full and on time each month; reducing your credit usage; or requesting a credit report and disputing any errors.

Companies with loans approaching maturity should try to figure out how to refinance the loan or roll it over “sooner rather than later,” Zandi said.

Consumers should also strengthen their “personal balance sheet” in case tighter credit triggers an economic downturn, Benz said. Be sure to have the money on hand in an emergency reserve to weather potential unemployment, for example, she said.

Those reserves can, for example, be stored in an emergency cash fund. A secondary line of reserves could come from establishing an equity line of credit now and having it on standby in the event of a job loss, Benz said.

Having three to six months of reserves to cover household necessities is a good starting point, she said. Older working adults and those with more specialized career paths may need more — closer to a year’s worth — because it can take longer to replace a lost job, Benz added.

Consumers should be aware that banks often retain the right to reduce the credit limit on existing HELOCs, said Allan Roth, a certified financial planner and accountant based in Colorado Springs, Colo.

Bank customers should also try to keep their savings with a bank within the Federal Deposit Insurance Corporation’s limit of $250,000 per depositor, per property category, Roth said. The federal government stopped uninsured deposits at SVB and Signature Bank, but that won’t necessarily be the case for future bank failures.