What is the credit crunch and what are its causes and consequences?

In recent months, the Italian credit sector has seen a decline in bond yields, thanks to the more accommodative monetary policy of the European Central Bank. Despite this, there has been an increase in the credit spread, or the difference between the yields of risky and risk-free securities. This indicates that investors are perceiving an increase in credit risk, demanding higher yields for riskier securities.

The increase in the spread means that the likelihood of some companies defaulting on their debt is increasing, increasing uncertainty in the market. Already vulnerable sectors, such as agriculture and automotive, are particularly exposed to this risk.

This increased perception of risk could affect the availability of credit for Italian companies. In fact, banks could become more selective and reduce the supply of loans, giving rise to a real credit crunch. A credit crunch could make it more difficult for many companies to access financing, with negative repercussions on the overall economy.

But what exactly does credit crunch mean and what are its causes and consequences? In this guide, we provide a simple definition and a clear explanation of what credit crunch entails, exploring its main causes and the consequences it can have for businesses and the economy in general.

What is credit crunch: meaning and definition

The term credit crunch (credit crunch) refers to a phase in which banks and financial intermediaries significantly limit the supply of credit, even if demand from businesses and families remains high. The criteria for obtaining financing become more stringent, rates may increase and overall loan volumes decrease.

This scenario can occur in periods of economic uncertainty or following restrictive monetary policies and can have negative effects on the real economy: corporate investments fall, hiring slows down and consumption is compressed. If the credit crunch persists, the risk is that of a progressive slowdown in growth, leading to a recession.

The causes that lead to the credit crunch

The causes that lead to the credit crunch are many and often interconnected. One of the main ones is linked to the economic situation: in phases of slowdown, companies struggle to generate revenue due to weak demand. This translates into an increase in non-performing loans on banks’ balance sheets and leads credit institutions to increase the barriers to granting loans.

Another key factor is the capital strength of the banks themselves. A bank with low levels of capitalization may be more inclined to grant loans only to customers with low risk profiles. This mechanism, known as “flight to quality”, penalizes those companies intending to finance riskier projects, such as innovative ones.

A credit crunch can also occur after phases of excessive credit expansion. When banks grant loans to subjects with high risk profiles or already heavily indebted, the risk of insolvency increases. Any losses that result end up weighing on the balance sheets, limiting the possibility of granting new credit.

A decisive role can be played by the monetary policies of central banks: these can cause a credit crunch by raising interest rates, requiring banks to have a higher mandatory reserve ratio or with a maximum ceiling on the ability of banks to grant loans compared to what they did a year earlier (so-called credit ceiling).

The devaluation of assets, such as real estate or financial securities, can also put pressure on banks’ balance sheets, especially if it results in significant losses.

The consequences of the credit crunch

One of the most frequent consequences of the credit crunch is the recession. The flight to quality mechanism pushes banks to select only customers considered to be the most solid, applying higher interest rates to compensate for the smaller number of loans granted.

In a context of greater prudence, credit institutions tend to retain liquidity instead of injecting it into the economic circuit. This tightening accentuates the contraction of available credit.

The result is a reduction in liquidity available to families and businesses: consumption decreases, companies struggle to finance new projects and investments. As a result, employment slows, uncertainty increases and the entire economic system suffers, with a negative impact on growth and market confidence.

Original article published on Money.it Italy. Original title: Cos’è il credit crunch e quali sono cause e conseguenze