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Imagine that you’re interested in getting a loan for your business. You shop around, apply with a few lenders, and get approved by them all. After comparing the offers, you find a good deal but aren’t quite ready to take the loan yet.
A few weeks later, you follow up with your favorite lender. While your revenue and credit scores haven’t changed, your application gets rejected. Why? This can happen as the result of a credit crunch — also called a credit crisis or credit squeeze.
Amidst fintech lenders closing up their small business operations plus recession rumors, there’s been a bit of concern about credit crunches, and if we’re in one. In this explainer, we’ll review what credit crunches actually are (hint: they may not be what you think), and what you should do to survive one.
In this article:
- What is a credit crunch?
- What causes credit crunches?
- A real-life example of a credit crunch
- What do credit crunches mean for small businesses?
- The difference between a recession and a credit crunch
- Are we in a credit crunch in 2023?
- What you should do if you can’t qualify for credit
- Does building business credit matter in a credit crunch?
What is a credit crunch?
A credit crunch occurs when there’s a sudden, sharp decline in the amount of credit available from financial institutions like banks, credit unions, and alternative lenders. As a result, both individual and business borrowers find it more difficult to access credit — especially subprime borrowers.
Pro Tip: There’s currently no specific definition of how sharp the decline of lending activity must be to determine a “credit crunch.”
What causes credit crunches?
Lending institutions profit from the interest and fees charged to borrowers. So, for lenders to stay in business, borrowers must repay their loans and fees. If too many borrowers default on loans around the same time, lenders not only lose a sizable amount of their forecasted profits, but can also lose a portion of the money they loaned out. As a result, they’ll need to tighten their credit standards and/or raise their interest rates to prevent further losses. When lots of lenders do this at the same time, you get a credit crunch.
So, what causes a group of borrowers to default around the same time? Both individuals and businesses default when they can no longer afford their payments, either due to a loss of income or an increase in borrowing costs. This can occur due to events, such as:
- A recession or depression
- A war
- A pandemic
- A natural disaster
- The Fed rapidly increasing interest rates
A credit crunch may also occur if the Federal Reserve increases capital requirements — the amount of liquid capital banks must keep on hand. If the liquidity of financial institutions falls short, it can rapidly reduce the amount of money they have available for loans.
Further, the federal government has a track record of introducing monetary policies that aim to reduce lending to control economic conditions such as inflation.
Credit crunch example
One of the most notable credit crunches began in 2007 when the real estate bubble popped, triggering a massive financial crisis. Banks had been handing out adjustable rate mortgages like candy to subprime borrowers (to meet the bottomless demand of hedge fund owners). The federal interest rate was low, housing demand was high, and housing prices were rising. As a result, many consumers saw it as a good time to invest in a home and gain some equity.
When the Fed began increasing interest rates, housing demand cooled, home prices began to drop, and the rates on all those adjustable bank loans spiked. Unfortunately, many borrowers were stuck upside down on their homes and unable to afford their mortgage payments.
As homeowners defaulted across the U.S. and home values plummeted, it sent shock waves through commercial banks, hedge funds, investors, savings institutions, insurance companies, Wall Street/the stock market — pretty much the entire financial system. Suddenly, the party was over, the bad loans were exposed, and the availability of credit was heavily restricted. Interestingly, some believe that the credit crunch was too extreme and actually slowed down the economic recovery.
Ben S. Bernanke, an American economist who was the 14th chairman of the Federal Reserve from 2006 to 2014, says, “Although the deterioration of household balance sheets and the associated deleveraging likely contributed to the initial economic downturn and the slowness of the recovery, I find that the unusual severity of the Great Recession was due primarily to the panic in funding and securitization markets, which disrupted the supply of credit.”
What does a credit crunch mean for small businesses?
When credit crunches occur, it’s harder for businesses to gain access to capital through products like bank credit cards and loans. As a business owner, you may find it difficult to finance major purchases like equipment, property, and inventory. Further, it can stall plans to expand operations and make it harder to survive an economic downturn.
All of the above can cause businesses to cut back on expenses, lay off employees, raise prices to improve cash flow, and put off growth initiatives. For the economy at large, credit crunches can lead to a rise in unemployment, interest rate increases, an overall slowdown of economic activity, defaults, and bankruptcies.
What is the difference between a recession and a credit crunch?
A recession refers to a temporary period of economic decline, which is typically identified when the Gross Domestic Product falls for two consecutive quarters. During these periods — trade, industrial activity, employment, and consumer spending all decrease. On the other hand, a credit crunch refers to a decrease in the amount of credit available from lending institutions. While one can often lead to the other, they are different.
Are we in a credit crunch now?
Now that we’ve covered the ins and outs of credit crunches, are we currently in one? While no one has sounded the alarm yet, there are a few warning signs to heed.
The Federal Reserve has been steadily increasing the Fed rate over the past year, which has made it more expensive to borrow across the board.
“With interest rates rising, many fintech providers have been shutting down their SMB services. We’ve seen Brex drop their small business products, Wells Fargo close their secured business credit card, AtoB tighten up their requirements, and now, Divvy is closing their credit builder program,” says Ken So, CEO of Tillful.
Meanwhile, inflation has hit record numbers, supply chain issues are still present, and industry leaders, including Experian and Bank of America, are predicting a recession in 2023.
All of these factors hint that businesses will face financial challenges in the upcoming year which will likely drive up the demand for credit. However, the supply and affordability of credit are worsening. Only time will tell if the credit conditions will be steep enough to warrant the declaration of another credit crunch.
What should you do if you can’t qualify for business credit?
If you can’t qualify for business credit yet, here are a few things you can do.
Work on Increasing Your Business Credit Score
First, check your business credit reports with Experian, Equifax, and Dun & Bradstreet. If you don’t have a report with all three or have negative records, you have some work to do.
A good first step is to open a secured business credit card that reports to all three agencies. To do so, you’ll need to pay a deposit upfront and then will be given a credit line in an equal amount. From there, use the card and pay your balance each month by the due date.
As you establish positive business credit lines, you’ll have a better chance of getting approved for additional credit accounts and tradelines. However, it’s important to make all your payments on time or the accounts can end up causing more harm than good.
Get Back to Basics: Reduce Costs, Increase Revenue
Business credit can be incredibly helpful, but it’s not the only way to gain access to capital. Another way to increase cash flow is to cut costs. You can review your expenses and look for opportunities to reduce spending. However, the key is to do so in a way that won’t be detrimental to your revenue or customer experience.
Should you still focus on building business credit during a credit crunch?
Building business credit is always a good idea as it can help to protect your business against financial downturns.
While credit crunches limit the borrowing power of consumers and businesses alike, those with poor-to-fair credit are hit the hardest. Borrowers with good-to-excellent credit scores will be more likely to qualify, even when lending standards tighten.
Though personal guarantees aren’t always a popular route to funding for business owners, in tighter market conditions, you may need to take one. To qualify for funding using a personal guarantee, it’s usually good to focus on raising your personal FICO score in addition to your business credit score.
All that said, business best practices dictate keeping tabs on more than just your business credit, which only reflects how well you repay your credit accounts. It’s also important to assess your overall financial health by monitoring metrics like cash flow, profitability, and expenditures.
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