A credit crunch is a way for banks to protect themselves from a cash crunch, should a run on the bank occur, and to avoid bankruptcy.
The current banking crisis, involving banks such as Silicon Valley Bank and Signature Bank, has brought to the table a serious problem that few have talked about that would affect millions of U.S. consumers: the credit crunch.
The credit crunch is what happens when banks significantly tighten their lending standards. Simply put, loans become harder to get. Banks that offer them may do so with more onerous terms, such as high interest rates or other restrictions, making such financing more expensive.
This situation makes it more difficult to buy cars, houses, make repairs and other large purchases. For businesses, there is no hiring, no expansion with new stores or factories. A tightening in bank lending causes the economy to cool, making a recession more likely.
Both Silicon Valley Bank and Signature Bank failed when depositors withdrew their money in a bank run, unable to meet the demand for cash. If consumers didn’t know it, banks don’t keep on hand all the cash coming into them. They make money on those deposits, investing part of the funds or making loans and receiving interest on them.
For example, among SVB’s problems was an investment in long-term U.S. Treasury bonds. SVB locked up billions of dollars in these bonds, which lost money when the Federal Reserve began raising interest rates aggressively last year to combat high inflation.
Some banks could weather potential bank runs by curtailing lending to have more cash on hand to meet customer repayments.
“We’re going to see a credit crunch in the U.S., and that’s starting to be priced into the market in a dramatic way,” noted Mike Novogratz, chief executive of Galaxy Digital, an investment management firm, in an interview with CNBC last week.
Before the recent chaos, banks had already been reducing the flow of credit to businesses and households.
In the fourth quarter of 2022, 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. They reported that they raised the minimum credit scores required to secure such loans, for example.
A significant portion also tightened standards for commercial and industrial loans to businesses, according to the survey.