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If you’ve been following the turmoil in the stock markets over the last few weeks, you are bound to have heard the term “credit crunch”, but what is it?

Basically, a credit crunch is a widespread shortage of credit within the financial system. It’s when banks suddenly decide that lending money is not a good idea as the financial climate has become too risky for them. As they define risk as the amount of bad debt that they are exposed to, the situation in the sub prime mortgage market in the USA is causing them major concern.

Being faced with millions of people defaulting on their sub prime mortgages, the banks are becoming very reluctant to lend to this sector. However as banks also share debts amongst themselves to reduce risk, they are now becoming reluctant to lend to each other.

As the credit crunch takes effect, the amount of credit available to businesses is being reduced as banks reassess who they will lend money to and, of course, this reduces the ability of businesses to grow through finance backed investments. Result: economic slowdown, possibly leading to a recession.

So this is why the stockmarkets have fallen heavily recently. The prospect of a credit crunch is causing fear of a recession, possibly on a global scale.

So how does this affect the average guy in the street? I published an article on Money High Street today that shows five ways in which a credit crunch could reduce the money in all of our pockets. It was kind of a gloomy article, but I feel we need to explain to people that there is a risk that the problems in the USA, and a resultant credit crunch, could tip the UK and other countries into a recession.