What is a Credit Crunch in Business?

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Written By Charlotte Miller

A lack of finance can be disastrous for business, and for the wider economy. In some extreme cases, where the lack of funding is systemic, the intervention of governments can become necessary. One notable manifestation of this problem is a so-called ‘credit crunch’.

What is a credit crunch?

The term ‘credit crunch’ refers to a downturn in lending. Because there isn’t enough money available, borrowing becomes effectively impossible. Lenders will often try to control demand by putting up rates, in order to cover the possibility of defaults. The effect of this can often be self-reinforcing.

How does a credit crunch happen

For an illustration of this phenomenon in action, we might look at the financial markets in the 2000s. Credit was freely available, even when the chance of a repayment was questionable. A culture of complacency had set in, and much of the debt was of a very poor quality. By the time 2008 came around, many banks had collapsed – and this started a domino effect, with the remaining financial institutions needing to pick up the slack. Eventually, a government bailout was necessary to keep the system afloat.

While it is to be hoped that governments and regulators will have learned lessons from this period, this doesn’t mean that we won’t see credit-crunch conditions in the future – even if they’re on a much smaller scale.

When the supply of credit is very low, a recession becomes more or less inevitable. Consumers become wary of spending, and businesses begin to struggle. Expansion becomes impossible, and the survival of many businesses is jeopardised.

How to protect yourself

So, what can you do as a business to make yourself more resilient to this kind of shock?

You might be tempted to collaborate with an expert consultant, which will help you to identify areas of weakness and work to overcome them.

The easiest and most effective strategy is to free yourself from debt. That doesn’t mean avoiding outside finance entirely; it does, however, mean paying back your loans promptly. Make sure you have a reserve on hand to cover essential payments, and that you aren’t about to run into liquidity problems. If you don’t have enough cash to honour your debts, or pay your employees, the gears that make your business run might quickly grind to a halt.

One essential step is to take a look at your credit rating. This is the score that different lenders use to collaboratively determine how likely you are to pay back a given loan. Establish what your rating is, via the major ratings agencies, and take steps to improve it. What these steps actually look like will depend on the circumstances of your business!