The Impact and Implication of the Credit Crunch in the UK - Essay Example

? CHAPTER THREE LITERATURE REVIEW The literature review involved a selection of recent research and professional journal articles with the intention of familiarising the researcher with the conceptual framework of the effect of the recent credit crunch in the UK on which the experiential research is based. These concepts, methods, processes and trends of the profession are described in sections 3.1 to 3.4 and the results of the literature review are concluded in section 3.5 3.1 DEFINITION OF THE CREDIT CRUNCH A credit crunch is defined by Bernanke and Lown (1991) as a decline in the supply of credit that is unusually large for a given phase of the business cycle. Credit normally contracts during a recession, but an unusually large contraction could be seen as a credit crunch. Jeffery, Avis and Wallace (2008) give a similar definition as Bernanke and Lown, stating that a credit crunch is a condition when borrowing money comes at higher interest and the borrower has to pay higher costs. Nevertheless, the economists Clair and Tucker (1993), who analysed the factors affecting the supply and demand of credit from 1986 to 1993, emphasise the causes of a credit crunch, stating that many economists, borrowers and regulators have expressed different views about the causes of a credit crunch, “like blind men examining an elephant, none of them are completely right or completely wrong”. However, this is due to every significant body of literature being viewed from different dimensions. Clair and Tucker (1993), in their journal, also state that bankers cite the cause of a credit crunch as lack of high quality loan demand, legislators blame overconfident regulators, borrowers say banks are too conservative and economists define a credit crunch as the cyclical decline in credit demand. Most analysts, including Jeffrey and Avis (2008), emphasise that the subprime mortgages are the sole cause of the current credit crunch, and they also add that these are not the only contributors to the problem. In fact, it is also the end result of lax lending by the banks and lenders undervaluing the risks and offering credit to sub-prime borrowers (people with poor credit histories) and consumers spending beyond their incomes for way too long. Likewise, Clare and Tucker (2008) argued that the heavy inflow of funds with low interest rates between 2002 -2004 has contributed to easy credit conditions, which encouraged both housing and credit bobbles; the Mortgage Backed Securities (MBS) was believed to be a part of the housing and credit boom. In addition, FT Intelligence (2009) emphasises that, between 2004 and 2006, US interest rates rose from 1% to 5.4%, causing a slowdown in the US housing market. Homeowners who couldn’t afford to keep up with the high interest rate began to default on their mortgages. Ellis (2008), on behalf of GLA Economics, states that high risk loans to people with weak credit histories soared to record levels and the impact of these defaults has been felt across the financial system because most of the mortgages had been packaged and sold on to investors and banks. Parkinson, Michael, Blake and Key (2009) analysed the impact and implication of the credit crunch in the UK. They define a credit crunch as a sudden cut in the availability of credit or loans, including mortgages, credit cards and interbank lending as banks worry about a lack of liquidity, and these financial crises are felt throughout the financial system. Brummer (2008) emphasises that the credit crunch, which began in August 2007, was due to the poor health of America’s mortgage intermediaries Fannie Mae and Freddie Mac. It shocked the financial market around the world and led to the economic crisis. As a result, the Lehman Brothers and Washington Mutual were the first dominant financial institutions to collapse in the credit crisis and become insolvent, say Dashan and Fabrikn (2008); other banks like Barclays and UBS announced fundraising via rights issue to boost capital ratio. Parkinson, Michael, Blake and Key (2009) have a similar view, stating that banks lost trust in each other and the whole UK interbank lending system completely seized up. In fact, these crises had a far-reaching effect on the world’s economies, and many economists predicted that this “Great Recession” of 2007–2010 could be the worst global recession since the 1930s. The National Bureau of Economic Research (2009) lists the impact of the credit crunch: food and fuel prices have soared, imports and exports to wholesale retail trade has slowed down; firms are struggling to survive; unemployment has increased; it is much harder to get mortgages; and some financial markets have almost collapsed. 3.2 BANK CRISES Early studies have been done by (Bhattacharya and Gale 1987) who focused on two of the essential functions performed by the money market in the banking system: endogenous – concerned about the rebalancing of the mismatch occurred in the inflows and outflows of the banks, in different periods; and the exogenous – concerned about how the liquidity among banks are changed from time to time, which are also characterised as the fundamental mechanism of monetary policy transmission (Fiordelisi, Molyneux and Previati 2010). The latest studies (Michaud and Upper 2008; Linzert 2009; Ewerhart and Tapking 2008; Linzert and Schmidt 2008) focused on the analysis of how the financial crises affected the money market, which had concomitant effects on the rates the banks charged borrowers. This study is crucial and strictly related to the banking system, and the scientific findings are held by the monetary authorities who are concerned about the economic slowdown caused by financial crises (Matthews and Thompson 2008; Milne 2009; Ewerhart 2008; Schmidt and Linzert 2008). In addition, studies (Michaud and Upper 2008; Linzert 2009; Ewerhart and Tapking 2008; Linzert and Schmidt 2008) have focused on analysis of how the financial crises effected the money market and had the contamination effects on the rates the banks charged their borrowers. This study is crucial and strictly related to the banking system, and the scientific findings are held by the monetary authorities who are concerned about the economic slowdown caused by financial crises (Matthews and Thompson 2008; Milne 2009; Ewerhart 2008; Schmidt and Linzert 2008). Further studies (Akerlof 1970, Stiglitz and Weiss 1981 and Flannery 1996) approve the application of an informational asymmetric approach both to the interbank market and the credit crunch; but other authors (Cassola et al.2008b) consider informational asymmetry as the main rational of the “contaminant” in the money market. The studies have also been concentrated on the modelling of the banks behaviour in the interbank market, paying close attention to their portfolio and information set (Heider et al.2009). The authors have identified three different phases in the life cycle of the interbank market, established using the counterpart risk and resources obtained from monetary authorities. The first phase indicates the situation in which the volume and interbank interest rates are under control, there is no liquidity shock, and banks are not willing to deposit money to the central banks. In the second phase, the banks lower the credit quality, causing an increase in the spread of interest rates to different levels of maturities, and the departure of lenders from the interbank money market. The reason for this is that the lower the credit quality of a lender, the higher the risk that investors will not receive the stated interest rate, and the greater the risk of default on the principal. Furthermore, the use of marginal deposits during the second phase also caused the lenders to leave the interbank market. In the third phase, the spread between the marginal lending rate and the marginal deposit rate was increased dramatically, and marginal deposits were extensively used, causing the overall interbank market to collapse. At this stage only the worst borrowers continue to operate in the collapsed money market (a supply vacuum), while the lenders continue to keep away from transactions, depositing liquidity at the monetary authority called (a demand vacuum). Similar views have been raised by Horta, Mendes and Vieira (2009) arguing that the rupture of the real USA mortgage bubble had an infectious affect across the globe, with the UK also experiencing a shock in its banking sector. This was due to the fact that, as Jon Moulton (2009) the British venture capitalist states, American and Britain had in effect the same complex and risky product; therefore due to the credit crunch, UK’s money market froze too. As a result, financing has become a great challenge and a loss of trust between banks has emerged. Therefore, the banking system has collapsed and is unwilling to lend to borrowers or to each other. Horta and Vieira (2008) stated that the financial stability initially caused banks to suffer from a huge lack of liquidity and result in both business and non-business consumer financial hardship. Commercial banks lend to each other less frequently and at much higher cost, either following an anticipation of losses and the consequent need to maintain adequate levels of reserves, or reflecting the turmoil in the financial system, motivated by the uncertainties about the real dimensions of the crisis (appendix). However, this suggests that if banks cannot get rid of their legacy problem it may make it harder for them to be good property and lending markets. According to Gieve (2008), firms who relied on asset-back securities to raise money suffered huge distresses. An example of this is Northern Rock; Northern Rock was the first casualty feeling the full blast of the credit crunch in 2007. Matthews and Thompson (2008) argued, that the Northern Rock faced a run on its deposits, leaving it short of liquidity to meet withdrawals, which was something that had not happened since 1866. Turner (2008) emphasised that Northern Rock was out of control as it was heavily relying on interbank lending; therefore, the bank was sensitive to the credit contraction. Meanwhile Murphy (2009) states, Northern Rock ignored the first warning sign of the crunch in late 2006 and the beginning of 2007, the bank even expanded their mortgages book by ?10 million. When the interest rates began to raise in 2006 these loan borrowers were clearly getting into difficulties, reflected by the growing number of repossessions Northern Rock were dealing with (Brummer 2008). Moreover, Sinai (2008) cites that Northern Rock had a high percentage of risky loans and a high percentage of loans financed through reselling in the capital markets and, when the subprime crisis hit, Northern Rock was no longer able to raise enough funds in the usual capital markets. Therefore the bank had to request emergency funds from the Bank of England. Matthews and Thompson (2008) argue that this resulted in a run on the banks by thousands of Northerns withdrawing funds via the Internet; in one day an estimated ?1 billion was withdrawn. This left the bank with further deficits (Appendix). However, as result of the credit crunch, other banks were also shown to have underlying problems and were performing as bad as Northern Rock. For example, HBOS (owner of Halifax) panicked to finance its balance sheet and, similar to Northern Rock, HBOS financed an expansion of lending by borrowing. The bank was badly affected by the challenging condition, a sharp decline in asset values and the dramatic contraction in the wholesale markets. Considering all these factors together, HBOS recorded a loss of ?10.8 billion in 2008 and HBOS profit before tax fell by 80% in comparison to 2007. However, similar situations have followed other banks. This was due to many financial institutions that could not raise enough money to sustain liquidity, as Turner (2008) argued, the shortage of credit or liquidity initiated serious losses due to default and payment delinquencies. This self-destructive cycle produced a slowing economy, overall weakening of stocks, soaring fuel prices, stagnant to negative job growth and the demand for the housing market slowed down. As a result, this put the government into pressure, yet for political and economic reasons. The Bank of England and the Central Bank had been injecting liquidity to restore the drying up of the interbank system and avoid bank failure. For example, Central bank reacted to the financial crises by cutting the interest rate at its lowest and engaging in so-called “non-standard measures of monetary policy;” these types of policy are thought to be going beyond changes in the interest rate, which represents the traditional tool that the central bank can aid to steer the monetary condition in the economy (ECB 2009). Because it is clear, when the banking system slows down at root, it distresses the economy as a whole. Blondal (2006) states that banks play a central role in the economy. For example, the banking sector controls the whole monetary system and you can imagine what would happen if that broke down. 3.3 HOUSING MARKET The UK housing market has suffered its biggest annual fall since the early 1990s. Blake, Key and Ball (2009) analysed the impact and implications of the credit crunch on the UK housing market, stating that the housing market peaked in 2006 and, since the onset of the credit crunch, there has been a sharp contraction in building following a slump in sales. For example, Barkeley Homes (2009) reported that, in comparison to the previous year, there was a decline of 50% in demand for housing in 2008. It was also noted that mortgage lenders’ reliance on customer deposit funding decreased from 72% to 55%. Kose, Leases, Maco and Terrones (2008) have provided connections between key macroeconomic and financial variables in the region of business and financial cycles in twenty-one countries over the period 1960–2007. These authors thought that the recessions associated with credit crunches and house price busts tend to be deeper and longer than other recessions. They have examined the implications of recessions, credit crunches, declines in house prices and equity prices, and the different overlaps in these twenty-one countries. They illustrate their analysis using line graphs and bar charts (see appendix C), to demonstrate the relationships between the credit crunch and the house prices in the market. However, Salisbury (2010) and Walayat (2007) argue that the high cost of interbank lending has greatly limited the supply of available mortgage funds. Many lenders have had to increase their own capital bases due to losses on investments and prudent and regulatory pressures in the face of the growing risk of sharp declines in the housing market and general economic downturns. Bain and Howell (2009) argue that if banks have further restrictions on their lending system, demand for services will grow weak. They also add that the Mortgage Bank’s stock prices fell from recent highs of ?12.50 to recent lows of just ?6.20, which is a 50% drop (see appendix). According to (news reference), in 2010 the housing market was still experiencing mixed conditions with “no sign” of much improvement. However, the Council of Mortgage Lenders (2010) believes that the housing market in 2010 might have been influenced by a variety of factors, such as the limited availability of credit, bad weather at the start of the year and changes to the stamp duty threshold. Merrison (2009) stated that the credit crunch is particularly hitting first time buyers, with lenders applying tighter criteria and demanding larger deposits; for example, the Council of Mortgage Lenders (2010) reported people who attempt to step up onto the property ladder only are accounted for 35% loans approved for the property purchase. Meantime, Ellis (2008) the existing homeowners are facing considerably higher repayment as mortgages come up for regeneration. Moreover, Ellis (2008) thinks the extent to which the credit crunch will depress activities in the real economy remains a major uncertainty at present, and it may put the property market performances in greater danger. Nationwide (2008) state that the experience of a previous market cycle, which occurred in the period 1991–1995 (see appendix), is currently being repeated, where increasing supply with a severe contraction in demand forces the housing market to plunge. Campbell and Cocco (2005) examined the correlations between house prices and consumer spending in Britain. The data was collected from the Nationwide house price index, from the years 1971 to 2006. They illustrate their analyses using line graphs (see appendix H). They state that in the past two series have tended to move together because house price movements can cause changes in spending. However, the connection also reflects the influence of common factors, similar to expectations of future income, which influence both house prices and consumption. In addition, Benito, Thompson and Waldron (2008) have come up with similar thoughts, arguing that there are many factors that could affect both house prices and consumer spending. For instance, an increase in people’s access to credit, a decrease in interest rates and development in expectations of income would all be likely to enhance demand for consumer goods and as well as demand for housing. In this case, there might be an association between higher house prices and higher consumer spending growth. However, as many people have been forced to default on their mortgages, and some cannot afford to buy properties, many people are turning to the rental market. 3.4 UNEMPLOYMENT Blanchflower (2010) believes the government’s severe “package of cuts and tax rises” has shaken consumer confidence in the outlook of the economy and their finances, and made them fearful of losing their jobs. Future (2008) analysed the geography of unemployment changes in Britain due to the credit crunch. It was suggested that from October 2007 to October 2008 the unemployment rate increased by 5.8%, which was the highest rate for eight years. However, amongst all the UK regions, the city of London is believed to be the worst affected in terms of job losses or redundancies (see Appendix). However, an increase in unemployment is a “lagging indicator” and is likely to play catch up to the unemployment rate. This will mean that the UK economy could experience massive costs in terms of benefit payments of an additional several billion a year. For example, according to the Office for National Statistics (2010) the number of people claiming Jobseeker’s Allowance in 2010 reached 1.46 million; in 2008 this number was below 800,000 and in 2009 the number of claimants rose to 1.5 million. Meanwhile, due to the rise in unemployment there will be a loss of tax revenues, which will further worsen the state of the government finances. UK national debts soared. Economics (2010) states that in 2010 UK public sector bad debt was ?953 billion, which is 64.6% of National GDP, and government’s annual borrowing for 2010-2011 is forecasted to be ?149 billion or 12.6 of GDP. However, Office International Statistics (2009) cites since 2008 national debt has increased sharply due to the economic recession (lower tax receiving and higher spending on unemployment benefits) and financial bailout of Northern Rock, RBS and other banks (appendix). The national debt increased from 30% in 2002 to 37% in 2007) this was due to a long phase of economic growth. In addition, analysts estimated the national debt to reach into 100% by 2012, although, it can improve through cuts on government spending and tax increases. However, unemployment issues did not meet the Labour Party’s mission to generate more jobs, and there have been even more job losses or redundancies due to the economic downturn. Keacock (2010) predicts that the economy is not yet recovering from the crisis and there will be more than 200,000 job losses in 2011. The Office for National Statistics (2010) adds that this year will be the “worst year for jobs” in 17 years. In addition, according to the Keep Britain Working (2009) campaign (see appendix), since the start of the recession more than half of all UK workers have experienced a cut in pay, a reduction in working hours or a loss of benefits. While ranking the UK districts in terms of employability, the Office of National Statistics (2008) states the city of Cambridge is believed to be the best performing region in the UK in terms of unemployment; in fact, from October 2007 to October 2008 unemployment there fell by 7.14% and it was also added that the levels of employment in transport, construction and banking are much lower than the national average. Meanwhile, Local Future (2008) arrive at similar points, stating that Cambridge has a high proportion of residents working in the hotel industry and this suggests that, with the decline in unemployment across the area, despite the current economic downfalls, tourism in the locality has not yet suffered. This indicates that, so far, the economy within Cambridge is sufficiently diverse to stand up to the effects of the economic downturn. However, Dolphin (2009) argues that, among the UK’s other regions, from the years 2007 to 2008 Crawley and Swindon have been positioned as the weakest performing districts in terms of employment. In addition, the city of Crawley is believed to have the highest unemployment rate in the UK. Local Future (2008) states that in mid-2007 Crawley’s unemployment rate doubled from 1.25% to 2.5%, and this increased the region’s unemployment to four times that of the national average of 27.29%. However, the reason for this is that Crawley had a lot of people employed by large businesses, such as XL, Zoom, Airways and First Choice, who made large-scale redundancies during the credit crunch; thus Crawley appears to have been suffering from a high level of business closures, which clearly contributes to the unemployment rate. Likewise, the city of Swindon has a very high unemployment rate and the redundancies from Honda in Swindon have contributed to these massive job losses. Harvey (2009) also mentions the closure of Woolworths, which caused huge unemployment in that region. 3.5 CONCLUSION In conclusion, it’s clear that there are a number of pertinent factors relating to the the conceptual framework of the effect of the recent credit crunch in the UK. In terms of the causes of the credit crunch the research demonstrated that there are a number of competing interpretive dimensions, including lack of high quality loan demand, overconfident regulators, and too conservative banks. Within the framework of the UK credit crunch the role of the money market is examined in terms of both endogenous and exogenous factors. Within this spectrum of understanding one of the crucial factors demonstrated was the three different phases of the lifecycle of the interbank market. In addition to these elements, factors relating to the monetary liquidity, and asset-backed securities. Many of these banking factors related to the credit crunch were examined in terms of Northern Rock bank. Ultimately, the factors demonstrated a self-destructive cycle producing a slowing economy, overall weakening of stocks, soaring fuel prices, stagnant to negative job growth and a slowed demand for the housing market. Factors relating the credit crunch to the housing market were examined in terms of recession length factors. Finally, the interrelation of unemployment and the credit crunch was analysed. Read More