Credit crunch refers to a condition in which the availability of loans is reduced. This translates into more stringent requirements for the approval of loans from banks. The reduction in loan availability may affect both businesses and individual borrowers.
A credit crunch may occur during a period of recession. Fluctuations in the different markets may contribute to this. For instance, a crisis in the real estate industry could cause lowered lending confidence. For certain banks, it may be difficult to issue more loans if they have an unusually high number of debtors who have defaulted on their loans.
In other cases, a credit crunch may be caused by changes in perception, especially if this involves the solvency of banks and other lending institutions. Governments can also contribute to the credit crunch by tightening controls on banks and other lending institutions.
A credit crunch usually translates into higher interest rates on loans, whenever a loan is actually approved.
A credit crunch may cause a ripple effect and have an impact on a nation’s economy. Its effects may even extend into the world economy. In a situation of recession compounded by a credit crunch, both individuals and companies may find it very difficult to pay debts and other obligations, thus becoming insolvent. In such a case, it may be necessary to liquidate the company’s assets. Another option is filing for bankruptcy. Such conditions make it even more difficult for any investments to be made.
In the case of a liquidity crisis, on the other hand, a business does not have access to the bridge financing that covers cash flow while it is waiting for inflow of cash. The business would then have to access other lines of credit to ensure that cash is available. Although this is different from being insolvent, during a time of crisis, it may not be as easy to tell the difference.