What happens during a ‘credit crunch’ and how you can prepare for one

on Mar21
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The recent banking crisis has fueled concern of a “credit crunch” and the resulting negative impact on households, businesses and the U.S. economy.

But what is a credit crunch and how might you prepare?

Loans would be tougher to get

During a credit crunch, banks significantly tighten their lending standards.

Loans become tougher to get. Banks that offer them might do so with more onerous terms like high interest rates or other restrictions — making such financing more costly.

Overall, it becomes harder, for example, for households to buy cars and homes or fix their roofs, and for businesses to hire, expand and open new stores or factories. A cooling in bank lending flows down to the economy’s bottom line, making a recession more likely.

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“Credit is the mother’s milk of economic activity,” said Mark Zandi, chief economist at Moody’s Analytics.

“I’d be surprised if we don’t see a pretty significant tightening of credit in the near term, among small and midsize banks,” he added.

Of course, there must be a happy medium in a well-functioning economy, Zandi said.

Money is leaving small banks and that's a very dangerous situation, says Trian's Nelson Peltz

Lending standards that are too loose can be damaging, too. During the financial crisis, for example, subprime mortgages issued en masse by banks triggered a housing crisis that ultimately cascaded into a deep recession.

Banks may prioritize a healthier balance sheet

Read more of CNBC’s coverage of the bank crisis

What this all means: To avoid a similar fate, many banks will likely prioritize shoring up their balance sheets to weather a potential bank run, experts said.

Banks might crimp lending in order to have more cash on hand to meet customer redemptions, for example. Also, if bank customers withdraw funds, a bank might then have a smaller stockpile from which to make loans.

“You’re going to see a credit crunch happening in the U.S., and that’s starting to get priced into the market in a dramatic way,” Mike Novogratz, CEO of Galaxy Digital, an investment management firm, said in an interview with CNBC’s “Squawk Box” last week.

A severe credit crunch isn’t a foregone conclusion, though.

The extent of the banking contagion remains unclear, Zandi said. The nation’s largest banks are also unlikely to significantly change their lending behavior, he added.

Banks had already been clamping down

Tim Robberts | Stone | Getty Images

How to prepare for a credit crunch

Those reserves might be stored in an emergency cash fund, for example. A secondary line of reserves might come from setting up a home equity line of credit now and having it on standby in the event of job loss, Benz said.

Having three to six months of reserves to cover household essentials is a good starting point, she said. Older working adults and those in more specialized career paths may need more — closer to a years’ worth — since it might take longer to replace a lost job, Benz added.

Consumers should be aware that banks often retain the right to reduce the credit limit on existing HELOCs, said Allan Roth, a certified financial planner and accountant based in Colorado Springs, Colo.

Bank customers should also try to keep their savings at any one bank within the Federal Deposit Insurance Corporation limit of $250,000 per depositer, per ownership category, Roth said. The federal government backstopped uninsured deposits at SVB and Signature Bank, but that won’t necessarily be the case for future bank failures.

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