What is a credit crunch? How it happens and how to prepare in 2023

Credit crunches can be challenging for small business owners. During these periods, lenders become hesitant to offer loans or credit, making it difficult for businesses to access the funds they need to operate and grow.

This can significantly strain business owners and lead to cash flow problems, especially if they rely on credit to maintain their day-to-day operations. In some cases, a credit crunch can lead to a recession, which can impact the economy and lead to higher unemployment rates and lower consumer spending. Let’s explore why credit crunches happen and how you can be ready to navigate them.

What happens during a credit crunch

During a credit crunch, banks tighten their lending standards—aka, it gets harder to borrow money. Loans are harder to get, and banks increase restrictions and rates. A credit crunch makes borrowing more difficult and expensive for small businesses.

The unwillingness to lend could be for various reasons, such as an increased risk of default or a decline in the availability of credit. In a credit crunch, small businesses can’t get loans or higher credit limits, which can hamper cash flow and growth.

Credit crunch vs. credit crisis vs. credit bubble

A credit crunch, credit crisis, and credit bubble represent negative economic conditions that can cause financial distress for businesses of all sizes. The terms credit crunch, credit crisis, and credit bubbles are similar but do not all mean the same thing. Here are the key differences:

• A credit crisis involves long-term, structural issues in the financial system, while credit crunches refer to short-term difficulties in getting loans. 
• A credit bubble happens when there's “easy” money—banks are very willing to lend—pushing asset prices to speculative levels. Businesses and investors leverage their assets to get loans and buy other assets, increasing prices. Eventually, the bubble bursts and prices fall. 

Note that credit bubbles can be a contributing factor to credit crunches or crises. 

Credit crunch vs. recession

A credit crunch and a recession are two different economic conditions. Credit crunches are periods when it’s difficult to get loans or capital. 

Recessions are broader economic slumps that include a decline in economic activity or stagflation. A recession is a period of broad economic decline that affects many sectors of the economy, usually lasting for an extended period.

During a recession, economic activity slows down, and businesses and individuals tend to cut back on spending due to a lack of confidence in the economy. This slowdown can lead to higher unemployment rates, lower incomes, and a general decrease in economic activity.

A credit crunch or credit crisis can be a component of a recession, but a recession can also occur for other reasons.

Causes of a credit crunch

Many factors cause a credit crunch, such as the bursting of a credit bubble or a period of too-lenient loan criteria. Here are three potential causes of a credit crunch: 

• Easy credit conditions. When interest rates are low and lenders are more willing to lend money, it can lead to a boom in borrowing. This can make it difficult for lenders to assess the risk of borrowers and can lead to a credit crunch when the economy slows down, and borrowers start defaulting on their loans.
• Bubble formation. A bubble is a situation where asset prices rise rapidly and then fall sharply. This can happen when investors become too optimistic about the future value of an asset, and are willing to pay more for it than it is worth. When the bubble bursts, investors can lose a lot of money, leading to a credit crunch as banks and other lenders become more cautious about lending money.
• Psychological factors. When people become fearful about the future, they may be less willing to take on debt. This can lead to a credit crunch as businesses and consumers borrow less money.
• Valuation of securities. When the value of securities falls, it can lead to a credit crunch as banks and other lenders lose money on their investments. This can make them more reluctant to lend money and lead to a decrease in credit availability.

These are just some of the causes of a credit crunch. It is important to note that a credit crunch is the result of a combination of factors and that the severity of a credit crunch can vary depending on the specific circumstances.

Effects of a credit crunch

What happens after a credit crunch starts? A recession can happen, but not always. One of the key consequences of credit crunches is higher borrowing costs for your businesses. It drives up interest rates for loans and credit, significantly impacting on businesses. 

There is a decrease in credit availability during a credit crunch, and banks get stricter with lending. Credit crunches can lead to slower economic activity, cash flow crunches, and an eventual recession. Here are some of the major effects of credit crunches: 

• Reduced economic growth: When businesses and consumers have less access to credit, they are less likely to spend money. This can lead to a slowdown in economic growth.
• Increased unemployment: When businesses can't borrow money to expand or hire new workers, they're more likely to lay off workers. This can lead to an increase in unemployment.
• Bank failures: When banks lose money on their investments, they may fail. This can lead to a loss of confidence in the banking system, making it more difficult for businesses and consumers to get loans.
• Financial crisis: A severe credit crunch can lead to a financial crisis. This is a situation where the financial system can't function properly, which can lead to widespread economic disruption.

Even if a credit crunch is already taking place, there are ways to future-proof your business; let’s look at a few ways.

How businesses can prepare for a credit crunch

Businesses can still work to weather times when credit is scarce even if a credit crunch isn’t on the horizon. The key actions below can help minimize the adverse effects of any challenging economic period. 

Strengthen your balance sheet

One of the key strategies to prepare for and weather a credit crunch is strengthening your balance sheet. This includes building up your cash reserves and reducing your debt. 

Assess your current debt load and pay down any high-interest debt you have. This includes all your debts, including credit cards, loans, and lines of credit. 

Lower your credit usage

Another way to get ahead of credit crunches involves lowering your credit usage. This means minimizing debt usage. Ways to lower your credit usage include:

• Building a budget: This will allow you to track your spending, which is key to reducing credit usage. You can then prioritize your necessary expenses over more discretionary ones. Make sure you’re paying down excess debt and credit cards.
• Consolidate debt: Try to renegotiate the terms of outstanding credit lines and loans. Negotiating with your creditors can lower your payments or interest rates. Or consider consolidating your debt into a lower-interest loan.

Build cash reserves

During a credit crunch, having cash on hand can be critical. If you have investments or excess cash in your business checking account, consider putting some funds in a savings account to build up a cash reserve. This can help you avoid additional debt or dipping into credit lines during tough times.

Cash reserves are the equivalent of personal emergency funds. A business emergency fund should cover three to six months of expenses. This will allow you to manage any credit crunches or declines in business.

Run your business with confidence 

Running a business during economic uncertainty is daunting. However, implementing practical steps, such as creating savings goals and building cash reserves, can prepare you for any unexpected challenges.

Remember that while economic downturns may come and go, maintaining financial stability and confidence is key to the long-term sustainability of your business. Accounting software like QuickBooks can help you maintain a good business credit score in any economic environment.