What is a Credit Crisis?

A credit crisis is a situation where available credit rapidly decreases. Also known as a credit crunch, a credit crisis can be precipitated by a number of factors and is often seen in association with a recession or depression. Recovering from a credit crisis can take a long time, depending on the nature of the crisis and general economic conditions.

Credit crises can take a number of forms. In some cases, credit availability shrinks across the board. People with existing credit accounts may find that they are reduced or curtailed, and individuals seeking to open new lines of credit may encounter difficulty. In other cases, credit is available, but only at very high interest rates and to individuals who are able to meet very high standards. This has the effect of closing consumers and small businesses out of the credit market because most do not qualify for offers of credit.

The creation of a credit crisis is something that happens over time. It can occur in response to changes in reserve requirements that force banks to reduce their overall lending as well as in periods of economic decline that lead to asset devaluation. Banks may grow concerned that collateral for current debts may not be worth as much as the debt and tighten credit to reduce their risk of exposure to bankruptcy. Changing norms in the financial industry can also result in tougher standards for credit that create a credit crisis.

As a credit crisis progresses and less money is available, the economy in general can begin to suffer. Many enterprises, from covering payroll to starting new developments, are fueled by commercial credit, and consumer credit drives the purchase of things like cars, appliances, and other goods. With fewer people buying, companies start making less money, and this can result in their cutting costs by firing employees and reducing production. A chilling effect is created as the credit crisis drags the economy down and credit standards become tighter and tighter in response.

Governments have an interest in avoiding credit crises whenever possible. When signs that a credit crisis is developing are observed, steps may be taken to increase available credit. If a government fails to take action, its economy may experience a downturn that makes the situation worse. Too much government interference can frighten investors and members of the general public, however. This forces governments to talk a fine line when determining when and how to intervene.