A ‘Credit Crunch’ Is Looming. Here’s How It Could Affect Your Wallet

It’s getting a lot harder to take out a loan these days. That goes for both businesses and consumers. Now, some experts are worried that a full-fledged “credit crunch” could have serious repercussions on the economy as a whole.

On one hand, making it harder to borrow money is the whole reason the Federal Reserve has been hiking interest rates since March 2022. Inflation was out of control — peaking at 9.1% in June 2022 — and the Fed sought to rein in soaring prices by making it more expensive to borrow money through a series of fairly predictable interest rate hikes.

Then, something largely unexpected happened: the failures of Silicon Valley Bank (SVB) and Signature Bank. The SVB failure was the second largest banking collapse in U.S. history. In the aftermath, experts are worried that banks could be tightening their lending standards faster than expected, possibly leading to a so-called “credit crunch.”

“Buckle up,” Paige Skiba, an economics professor at Vanderbilt University who specializes in high-interest credit, tells Money in an email. “It’s already here.”

What is a credit crunch, exactly?

In the words of the Fed’s own economists, a credit crunch is “a dramatic worsening of firm and consumer access to bank credit.”

In slightly different terms: If there’s a credit crunch, businesses and consumers won’t be able to get loans when they need them, and that can slow the economy down or even lead to a recession.

Recent data shows that banks have indeed been tightening their lending standards. Starting back in the third quarter of 2022, it was getting tougher for consumers to get access to credit, according to the Fed’s quarterly survey of senior loan officers. That trend continued in the fourth quarter as well.

At the end of 2022, the tighter lending standards were largely due to the Fed’s rate hikes. As Randall Watsek, a financial advisor at Raymond James, explains it, people were already taking their savings out of banks — because it was earning hardly any interest — and investing it in money market funds and treasury bills that offered returns of 5% or more. These rates have been difficult for banks to compete with. And with lower cash on hand due to falling deposits, banks have been getting pickier with lending out money.

So if these issues are ongoing, why all the commotion about a credit crunch now? The rippling effects of the recent banking meltdowns have accelerated the trend, though the exact impact is still an open question.

“We have seen a huge flow of deposits out of the banking system in the last several weeks to money market funds and other types of investment[s],” Rohit Chopra, director of the Consumer Financial Protection Bureau, said during a Washington Post Live event Tuesday.

The Fed’s next quarterly survey of loan officers, to be released in May, should give clearer insight into how banks lenders are reacting to the failures of SVB, Signature and other firms. Data that’s already available suggests the picture won’t be pretty.

According to a separate Fed report that tracks the balance sheet of commercial banks in the U.S., bank lending declined by about $105 billion in the final two weeks of March — the fastest decrease on record dating back to 1973.

Torsten Slok, chief economist at the financial firm Apollo, views this as a clear sign of a credit crunch. In a recent note, he wrote that the immediate panic following the recent bank failures seems to have calmed, but the behavioral pullback in lending by banks is starting to weigh on the economy.

“In short, the credit crunch has started,” he added.

How a credit crunch could affect you

During a credit crunch, loans, credit cards and mortgages might be tough to get. Banks and other lenders dramatically tighten their standards — meaning they’re much pickier deciding who is worth of getting their money. This usually translates into higher credit score requirements for borrowers, higher interest rates on loans or both.

Raymond James’ Watsek recommends holding off on getting loans for big projects or new home purchases while a credit crunch is playing out. Because of the more onerous terms, a credit crunch is generally not a great time to take out any big loans, if you can avoid them. “Preserve your liquidity as best you can,” he says.

In other words, try to have cash on hand to see you through the crunch, such as an emergency savings fund of at least three months — but up to a year or more is ideal, Watsek says.

“Consumers can work to keep their credit score high,” Skiba with Vanderbilt University says, “so that they will be ranked high by lenders when they are ready to lend.”

On the other hand, Watsek says that if you have ample savings and don’t really need loans, a credit crunch could be a positive thing for your nest egg. “It could actually be a benefit to you because you get higher interest rates on your savings,” he says.

Banks have recently lost a lot of deposits due recent bank runs on top of the underlying trend of folks moving their money into non-bank accounts offering more attractive returns.To try to lure depositors back, Watsek explains that some banks are offering high interest rates. For example, many certificates of deposit (CDs) are now paying APYs of 4% and 5%, but it’s unclear how long banks can afford paying out those rates.

Ultimately, the effects of a credit crunch depend on your specific situation, Watsek says. Some folks may benefit from better interest rates on their savings, while people who need credit will likely be in a tougher spot.

Whatever the case: “Definitely don’t panic,” Skiba says. “Crunches don’t last forever. They are transitory.”

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