Prepare for a 'credit crunch' by knowing what happens during one

The recent financial meltdown has increased worries about a "credit crunch" and its detrimental effects on Americans' households, businesses, and economy.

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However, what is a financial collapse and how can you be ready for one?

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Lending would be more difficult

Banks dramatically tighten their lending conditions during a credit crunch.

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Loans are harder to obtain. Banks who provide them may do so under more stringent conditions such as elevated rates of interest or other restrictions, increasing the cost of such financing.

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In general, it becomes more difficult for businesses to hire new employees, grow, and open new stores or factories as well as for households to buy vehicles, homes, or maintain their roofs. A decrease in bank lending affects the economy's bottom line and increases the likelihood of a recession.

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According to Mark Zandi, chief economist at Moody's Analytics, credit is the lifeblood of economic activity.

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In the near future, among small and midsize banks, "I'd be astonished if we don't see a very severe tightening of lending," he continued.

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In a healthy economy, there must undoubtedly be a happy medium, according to Zandi.

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Very lenient lending criteria might sometimes be detrimental. For instance, during the financial crisis, banks' massive issuance of subprime mortgages sparked a housing problem that ultimately led to a severe recession.

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A stronger balance sheet can be given priority by banks.

With the banking issues that have surfaced over the last two weeks, a credit crisis appears likely.

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When depositors hurried to withdraw their money, and the banks were unable to keep up with the demand for cash, Silicon Valley Bank and Signature Bank failed.

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Customers' cash isn't all that banks keep on hand. By investing some of the money or lending it, they profit from those deposits (and receiving interest payments).

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A long-term U.S. investment was one of SVB's issues. Treasury securities. SVB invested enormous sums of money in these bonds, which suffered losses as the Federal Reserve rapidly increased interest rates last year to combat excessive inflation.

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What it all means: According to analysts, many banks will prioritize strengthening their bank balances to withstand a potential bank run in order to avoid a similar fate.

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For instance, banks may restrict lending so that they have more money on hand to cover client redemptions. A bank may also keep a smaller stockpile to use to offer loans if bank customers withdraw money.

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According to Mike Novogratz, CEO of Galaxy Digital, a wealth management company, "you're going to see a credit crunch developing in the U.S., and that's starting to get priced into the market in a dramatic way" last week.

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But, a major credit crunch is not inevitable.

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According to Zandi, it's unknown how far the banking contagion has spread. The biggest banks in the country are likewise unlikely to alter their lending practices much, he continued.

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Banks had already begun to tighten controls.

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Even before the recent mayhem, banks had been restricting the supply of credit to families and companies.

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According to the Federal Reserve's most recent Senior Loan Officer Opinion Survey, banks reported tightening their rules for credit cards, lines of credit based on home equity, auto loans, and other consumer loans in the fourth quarter. For instance, they noted raising the minimal credit ratings needed to qualify for such loans.

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According to the poll, a sizeable portion also tightened criteria for commercial and industrial financing to enterprises.

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Even without the current banking scandals, Christine Benz, director of personal finance at Morningstar, believes that many institutions would naturally be looking to maybe [tighten standards] given concerns about a recession.

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How to get ready in case of credit crunch

Consumers can take a few actions right away to get ready for a potential credit crisis.

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Make sure your credit is "as attractive as possible be the case" if you have an impending credit demand, said Benz.

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That could entail making sure you pay off all of your credit card debt and other obligations on time and in full each month, lowering your credit utilization rate, getting a copy of your credit report, and disputing any inaccuracies.

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Companies with loans that are about to mature should look into refinancing them or rolling them over "sooner rather than later," Zandi advised.

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Also, consumers should strengthen their "personal balance sheet" in case tighter credit leads to an economic slump, according to Benz. Make sure you have enough money on hand in an emergency fund, for instance, to handle probable unemployment, she advised.

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These funds could, for instance, be kept in an emergency money fund. Setting up a home equity loan today and keeping it available in case of job loss could result in a supplementary line of reserves, according to Benz.

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A decent place to start, she advised, is with three to six months' worth of reserves to meet living expenses. Since it could take longer to replace, older workers and those in more specialized job paths may require more, closer to a year's worth.

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Customers should be aware that banks frequently reserve the right to lower the credit limit on active HELOCs, according to Colorado Springs-based certified financial adviser and accountant Allan Roth.

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According to Roth, bank customers should also make an effort to preserve their deposits at a single institution within the $250,000 per depositor, per ownership type, limit set by the Federal Deposit Insurance Corporation. Uninsured deposits at SVB and Signature Bank were backed by the federal government, but this won't always be the case in the event of other bank failures.