What’s a credit crunch? The feared bank phrase that may lead to a recession

As the dust starts to settle following the collapse of Silicon Valley Bank and Signature Bank in March, economists are warning of cracks in the system that started spreading even before the failures. Under conditions of banking turmoil, some are worried credit tightening will become a credit crunch.

A credit crunch is a decline in lending activity driven by a shortage of funds. Or, as Moody’s Analytics Chief Economist Mark Zandi puts it, “the inability of households and businesses to get the credit that they need.” It’s a phenomenon that can have a big impact on the economy and its growth.

“I’m getting really nervous now that an economy that I thought was going to dodge recession is now at much greater risk of falling into one and it could be quite severe because bank credit is the lifeblood for small businesses,” Pantheon Macroeconomics Chief Economist Ian Shepherdson said during a CNBC interview.

Following March’s Federal Open Markets Committee meeting, Federal Reserve Chair Jerome Powell said the second and third largest bank failures in U.S. history “are likely to result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes.”

But the train was already on those tracks before the banks’ closures. Loan activity has been trending down due to the central bank’s aggressive actions to tame inflation. Over the last 12 months, the Fed raised its benchmark interest rate from near 0% to nearly 5%.

The latest Fed survey found roughly 44% of banks reported tightening standards for business loans in the first quarter of 2023. With the exception of the COVID-19 pandemic, it’s the highest share to say that since 2009 in the wake of the Great Recession.

“The possibility of the restriction of credit to be so significant that under almost any terms you can’t get a loan, that’s certainly a risk of something that may happen,” Zandi told Reuters.

The most recent example of a credit crunch was after the 2008 financial crash. Financial institutions had trillions of dollars in subprime mortgages that were essentially worthless. Banks that were able to weather the storm didn’t have the resources or risk appetite to lend at their previous pace. Even highly-qualified individuals and businesses struggled to get approved.

Access to capital fuels growth in the U.S. economy and that credit crunch significantly slowed expansion in the years that followed.

“The ‘08, ‘09 financial crisis is in a league of its own,” Zandi said. “What we’re experiencing now, it doesn’t feel very good, it’s very uncomfortable, but it’s nothing compared to what we suffered back in that crisis.”

The Federal Reserve is monitoring how commercial banks tightening credit will affect its policies moving forward.

“The key is we have to have policies to bring inflation down to 2% over time,” Powell said in March. “It doesn’t all have to come from rate hikes. It can come from tighter credit conditions.”

Reaching the Fed’s 2% inflation target without entering a recession, known as a soft landing, was already a challenge with the central bank’s limited, blunt toolset. But at least the Fed has control over those tools. A credit crunch could bring in a whole new set of unknowns.

“I’m much less confident in my optimism about avoiding recession than I was two weeks ago because of the banking crisis,” Zandi said. “There’s a lot of uncertainty here. How significant is this credit crunch going to be? How big an impact is that going to have?”

Reuters contributed to this report.

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