A credit crunch could be coming. Here's what that could mean for getting a loan

A credit crunch might be on its way.

Signs of banks tightening credit have already popped up in recent months as the Federal Reserve has hiked interest rates to the highest level in more than a decade to combat high inflation.

Higher interest rates mean the economy is more likely to slow, unemployment rates to tick up and borrower delinquencies and defaults to rise. In other words, a recession is more likely.

"If you're a banker, you say, 'Well, if there's a higher chance of a recession, I'm less interested in making loans to companies that might go bad,'" said Andrew Winton, a finance professor at the University of Minnesota.

Add to that the recent banking turmoil — high-profile failures of Silicon Valley Bank and Signature Bank and the related fallout — and economists and financial experts say the confluence of these factors could push the U.S. into an all-out credit crunch in the coming months.

Banks curtail lending in a credit crunch, making it harder for businesses and consumers — especially those with weaker credit — to acquire loans. The last major credit crunch happened during the financial crisis of 2007-09.

"With rising interest rates, credit was already beginning to tighten, and it was going to continue to tighten," said Greg McBride, chief financial analyst for Bankrate.com. The recent banking issues "just accelerates that process. It gets us further down the pathway."

Dorothy Bridges worries about what that will mean for many small businesses, especially ones people of color own.

"When the rest of the small-business world catches a cold, our businesses tend to develop pneumonia," said Bridges, CEO of Minneapolis-based Metropolitan Economic Development Association, or Meda, a nonprofit that provides lending and consulting to entrepreneurs of color who have trouble accessing credit from the traditional banking system.

In recent weeks, some businesses have already begun reaching out to Meda asking for help with refinancing their loans.

"Generally, when banks tighten credit, they're making a decision not only for new deals that come in the door but also for existing clients, saying at renewal time, 'We are no longer able to support that credit,'" she said.

Rising interest rates have also made it difficult for Meda's clients to secure new loans and service existing ones with other lenders. As a result, some of them are postponing hiring new employees, and others are delaying expansion plans.

The Federal Reserve's quarterly survey of senior loan officers shows banks have tightened credit in the last couple quarters for many kinds of loans, including commercial and industrial, commercial real estate, credit cards and auto. In the latter category, for example, about 44% of lenders said they had narrowed standards in the last three months of 2022.

Results from the next survey, expected next month, will provide a glimpse of how much more lenders restricted credit in response to the recent bank failures.

Meanwhile, in another survey of households from the New York Fed, 58.2% of consumers reported it was harder to obtain credit in March than a year ago, the highest percentage since the survey started a decade ago.

The newer wrinkle that could make credit constrict even further is the outflow of deposits from smaller and medium-sized banks to bigger banks following the collapse of Silicon Valley Bank and Signature Bank.

That deposit flight appears to have stabilized for now. But those banks that lost some deposits might be less inclined to lend as much for a while. Others might just want to increase their liquidity positions to have a wider safety net.

"They'll say, 'We've got less money to lend, plus there may be a recession coming,' so they will tighten up even more," said Winton. "It's probably making things somewhat worse."

It's unclear to what extent the deposit reshuffling affected banks in Minnesota, but some of the larger regional banks in the state have said they didn't see any unusual activity.

St. Paul-based Bremer Financial, Minnesota's fourth-largest bank, is among those to have said its deposit levels remained fairly stable. Keith Ahrendt, its chief credit officer, said its credit standards have also remained pretty steady.

"For us at Bremer, it's pretty much business as usual," he said. "We haven't changed our underwriting guidelines. We haven't tightened our credit terms at all, really."

He added he knows of a few banks that have pulled back some, but he doesn't know of any doing so to the point where they're not lending.

"Factoring in current market conditions and higher interest rates, it's probably a little tougher to qualify with a higher payment amount for some borrowers," he added.

For businesses looking to obtain a loan in the coming months, Ahrendt recommended doing some more planning and, where appropriate, spreading projects out across a longer period of time if they don't need the financing all at once.

"At some point, the Fed is going to probably stop rising rates and maybe rates start to turn a little," he said.

Financial experts said if consumers and businesses are not comfortable with where rates are right now, they might want to hold off if they can until they start coming back down.

"Improve your credit score," said McBride, offering tips for how consumers can better position themselves for a loan in the current environment. "Boost your savings. Pay down other debt. Those three steps make you a better borrowing candidate."

He added a credit crunch is not a foregone conclusion, pointing to a settling down in the financial sector in the past few weeks.

"But that doesn't necessarily mean we're completely in the clear," he said. "It will be maybe a few months before we can really assess whether financial stability has fully returned or not."

Meanwhile, Fed officials are weighing future rate increases against the credit tightening, which should also help slow down the economy.

Neel Kashkari, president of the Minneapolis Fed, said last month the recent banking stresses bring "us closer to a recession." But he added it's still unclear how much of a widespread credit crunch will materialize as a result.

"This is something we're monitoring very, very closely," he said.