Credit Crunch Effects on a Decision-Making Process - Term Paper Example

Introduction Credit crunch has been traditionally defined as an excess demand for credit under prevailing interest rates, or a situation where creditis rationed through non-price mechanisms. More often now, the term is used to describe a fall in real credit to the private sector (Lindgren, 1999, p. 24). According to Clair and Tucker (1993), a credit crunch occurs due to an unusually large contraction of credit. When an economy is driven to credit crunch due to a decline in the growth of credit, it is difficult to analyze whether the cause is a shift in the demand or in the supply of credit. Taking the Asian example, in the years succeeding 1997, both the demand and supply were determined to have been affected by the credit crunch. Demand for credit declined as consumption and investment were sharply reduced due to uncertainty, overcapacity, weakening economic conditions, and the negative wealth effect arising from a fall in asset prices. The borrowers lost credit worthiness, which made banks reluctant to lend, even at higher interest rates. The financial system will also be affected in such a situation, resulting in the decline of supply of credit, which further weakens its demand (Lindgren, 1999, p. 24 - 25). According to Jubak (2007), in a credit crunch, lenders stop lending and credit becomes tough to obtain. Credit crunch is a crisis that feeds on fear and uncertainty. A lender can compensate for fear by raising interest rates, tightening credit standards or writing more protective covenants into the terms of a loan. But if the size of the losses is uncertain enough, lenders cant compensate for the additional risk because lenders dont know how large that risk might be. Credit crunch is characterized by extremely depressed liquidity and deteriorated balance sheet positions for households, corporations and financial institutions; sharply increased interest rates as all sectors scramble for remaining available funds; rising yield differentials as investors sell risky investments and switch to safe assets; a severely depresses stock market; and the inability of many borrowers to obtain funds at any cost (Wolfson, 1994, p. 22). The supply of funds is restricted not only because of the tight monetary policy by reducing bank reserves, but also due to smaller deposit inflows to financial institutions and reduced savings flows (Wolfson, 1994, p. 22). Causes of credit crunch In order to study the causes of credit crunch, Clair and Tucker (1993) focus on the Texas banking industry and the credit crunch phase of seven years starting 1986. The authors studied the factors affecting supply of loans from banks as they believed banks represented the vitally important source of credit. In Texas, during the 1990-91 period, total loans at domestically chartered commercial banks grew only 1.7 percent as opposed to an average of 7.1 percent during earlier recessions. Demand for loan was weak as the credit worthiness of borrowers was less and supply was weak due to decline in bank capital resulting from severe loan losses during recession. During an economic slowdown, demand for credit declines and the supply also contracts as loans become riskier. In a typical business cycle, once recovery sets in demand increases and banks begin lending again. However, in severe downturns, the ability of banks to start lending once the recovery sets in is restricted. This is because, during recession, the larger than normal loan losses result in larger than normal reductions in bank capital and numerous bank failures. This hinders supply of credit and causes a credit crunch to occur (Clair and Tucker, 1993). Loan losses not only resulted in reduced bank capital but also raised minimum capital standards. Regulators raised the risk-based capital ratios and replaced primary capital ratio requirements with leverage ratio requirements. Under these circumstances, many institutions failed and its assets were taken over by deposit insurers who sell these institutions. Banks that did not fail but were undercapitalized sold their assets to improve leverage ratios (Clair and Tucker, 1993). Bank examiners have a huge impact on credit decisions and in the event of enforcing safety and sound guidelines, tend to hinder bank lending. Conservative examiners could increase loan loss provisions and leverage ratios, thereby constraining capital for lending. Severe recessions could alter perceptions of risk of bank supervisors. In the event of a severe recession, bankers will re-evaluate their risk taking behavior and require more capital to cushion against it. In any case, their willingness to supply credit will be reduced. Borrowers who counted on continuous supply of credit by their bankers will be deeply affected with their uncreditworthy standard. And finally, banking remains one of the most regulated industries in the US. Over regulation is one of the biggest concerns in the banking industry. The costs and benefits of every regulation affect the supply and demand of credit for bankers. In Texas, the regulatory burden not only contributed to the credit crunch by imposing a cost on banks, but also discouraged lending by imposing higher cost on lending than on investing in securities (Clair and Tucker, 1993). Credit crunch and corporate decision making A credit crunch is a natural phenomenon in economies where weak and inefficient financial and banking systems face an uncertain and rapidly transforming economic environment. Credit and banking sector reforms play an important role in channeling funds to profitable investment opportunities. More competitive banking markets have a positive contribution on economic growth (Colombo & Stanca, 2006). Successful businesses and higher savings and investments by individuals fuel economic growth. During a credit crunch, both these factors are affected as credit becomes harder to obtain. A rise in short-term interest rates would have an adverse effect on the credit crisis of an economy. If the government raises short-term interest rates, the financial market would collapse, the debt crisis would worsen and the credit crunch would accelerate. Keeping this perspective in view, the Federal Reserve left short-term interest rates alone during the credit crunch and instead sacrificed the dollar, which has been facing devaluation since then. During a credit crunch, interest rates are high prohibiting borrowers from the ability to borrow credit. This leaves the economy short of funds available for business and investments. Many business enterprises maintain long-term credit with the financial institutions they deal with on a regular basis. Such businesses thrive on constant circulation of funds between them and their banker. When a credit crunch hits the economy, bankers become reluctant to lend, as creditworthiness becomes an issue between them and the borrowers. Especially with higher interest rates, borrowers will find it difficult to pay back loans and this creates an even bigger breach between the lenders and borrowers. Credit crunch could also have a global impact affecting many economies in its wake. The recession in the US has led to dollar devaluation, which has had implications in Asian and European markets. The rise in oil prices against the fall in dollar has also raised gold prices in most Asian countries. Interest rates have also been on a rise as a result of the global credit crunch and borrowing has become a very expensive affair. Taking an example, there has been renewed rise in the money market rates in Europe, with the three-month LIBOR at nearly 6 percent. To counter this, the Bank of England’s monetary policy has decided to cut interest rates on account of rising inflation and aggressive cut on rates by the Federal Reserve. Along with cuts in interest rates, central banks must also flood the money markets with liquidity, making credit available to all. The credit crunch also creates a backlog of mortgages gone bad with a lot of banks incapable of recovering from them. The central bank should mop up these backlogs by buying them at distressed prices and allowing banks to close books with losses. Contradicting popular assumptions, Warren Buffet believes that credit crunch has nothing to do with the stocks he trades in the market. He states that the decision to buy a stock solely rests on what one thinks about the business and the valuation of the stock. When the fundamentals of a stock looks good, the cheaper the stock, better are the chances of making profit from it. The only important factor while buying a stock is the fundamentals of the business and the price at which it sells. He also comments that anyone who rests his or her decision to buy or sell a stock based on Fed’s verdict is not destined to have a great financial future. Taking the example of US and EU economies, credit crunch and its effects on corporate decisions have been illustrated below: Credit crunch in the US With shrinking jobs, plummeting housing prices and swelling debt levels, the US that pioneered the no-money-down mortgage is on the brim of a credit crunch. In the 1950s and 1960s, when credit cards grew in popularity, many Americans spend money virtual money without caring for substantiating the same with paper money. By the 1980s, many Americans were entrusting their savings to the booming stock market and using the profits to spend in excess of their income (Goodman, 2008). The housing slowdown, which resulted in deteriorating real estate prices, in turn resulted in higher mortgage rates and made it difficult for homeowners to make payments on time. Without rising prices, resale was not an option and this forced many out of their homes. This consequently resulted in losses for sub prime lenders who generated loans to marginal borrowers based on unsubstantiated incomes and a belief that collateral values would continue rising. These factors led to increased pressure on regulators who imposed more and more intense bank examinations, tighter standards and subjective classification of loans. Lenders were intimidated into not lending with the above restrictions that created a hindrance to their earnings. Thus credit crunch was formed in the US, which lowered money supply and worsened the recession in the economy (McHugh, 2007). Credit has proved to be especially tight in the US as the bursting of the housing bubble spread misery across the financial system. According to government data, in 1984, Americans were saving more than one-tenth of their income. A decade later, the rate was down by half. Now, the savings rate is slightly negative, suggesting that, on average, Americans have been spending more than their disposable income. Americans are now forced to increase their savings and cut back on luxuries. Over the long-term, the economy should keep growing at a pace that reflects steadily improving productivity and population gains (Goodman, 2008). Credit crunch in the EU The European Union is in the middle of a credit crunch and is struggling to reconcile the fluctuating performance of its diverse national economies. As it faces long–term challenge from emerging economies like China and India, the task of fostering competitiveness and growth is more urgent now than ever. Padmore, Purdy and White (2004) explore five key areas that they believe the new European Commission and Parliament should concentrate on to achieve a more sustained growth. The success of Denmark, Sweden and Finland as competitive economies is attributed to their economic success coexisting with at least three social commitments that positively impacts their growth. They emphasize on people protection rather than job protection, lifelong learning as essential to stimulate labor-market mobility and innovation, and company taxation is kept low to provide further incentive for investment and entrepreneurship. A collaborative approach by both government and businesses can help drive high performance at both the company and national economy level (Padmore, Purdy and White, 2004). Financial outlook in Europe The credit crunch of mid – 2007 and its continuing consequences has clouded the short-term outlook in investing banking, reflects Gillmann, Heidegger and Heidrich (2008). Their outlook on corporate banking in Europe is positive over the next 18 months for those players positioned to benefit from profitable growth areas. Although current financial crisis and higher funding costs will affect products such as straight loans, asset-backed securities, and leveraged finance, increased interest rate spreads and a more risk-averse business environment can help promote other products and services, including cash management and corporate risk mitigation. Banks should perceive current market conditions as an opportunity to revisit unsustainably low margins and ensure that their lending is profitable with a significant potential to boost fees as well as net interest income. Banks should also follow rigorous and standardized risk assessment methods to price loans. Banks should increase their payment and deposit revenues and segment their corporate clients using structured and disciplined account-management approaches backed by incentives focusing on total customer value. Banks should also put greater emphasis on fixed-income and other derivatives. Customizable product structures bring both quality and efficient scale to the hedging of risks in foreign exchange, interest rates, and commodity prices (Gillmann, Heidegger and Heidrich, 2008). Over the next 18 months, the outlook for corporate banking is clearly less bright than it has been in recent years. Other types of banking business will probably encounter greater challenges, however. By exploiting the opportunities we have laid out, corporate-banking executives can expect solid revenue growth in the short to medium term. To what extent, however, depends on how shrewdly banks address specific markets and how efficiently they organize their sales teams and back-office operations. A full-fledged change in midterm strategy is not an appropriate response to the credit crunch. But a sharper approach to markets, combined with greater clarity in selling and greater efficiency in execution, will pay off handsomely at this stage of the cycle (Gillmann, Heidegger and Heidrich, 2008). Credit crunch and relevant theories Van den Heuvel (2002) states that there are at least two theoretically distinct ways in which the level of bank capital can change the impact of monetary shocks on bank lending - through the traditional bank-lending channel and through a more direct mechanism namely "bank capital channel." Both these channels derive from a failure of the Miller-Modigliani theorem for banks. According to this theory, a bank’s lending decision is independent of its financial structure. The theorem also holds that as banks will be able to find investors willing to finance profitable lending opportunities, the level of bank capital is irrelevant to lending. This theory is challenged by the fact that monetary policy has a direct effect on the supply of bank loans and thus on the real economy. By lowering bank reserves the policy reduces the extent to which banks can accept reservable deposits and this affects the lending capacity of banks. The rationale behind CAPM is that investors can avoid a certain amount of risk by holding a diversified portfolio of assets. But risks such as global recession cannot be eliminated through diversification and such investors who take on the above risk must be awarded with returns more than those who invest in safer assets such as treasury bills. In times of recession or credit crunch, there is less credit available for borrowers and the risk in investments is much higher than normal markets. In such a case, banks instead of lending increase their holdings of liquid and safer assets which carry lower weights in the computation of capital adequacy requirements, thereby reducing supply of credit (Lindgren, 1999, p. 26). The efficient market theory, on the other hand, hypothesizes that the stock market is efficient and that stock prices follow an upward bias and as such stock price movements cannot be predicted. The theory follows that the stock prices reflect all the known information in the market and prices change only due to unexpected news. But practice has proved otherwise; the risk of inflation and a rising US recession has pressured the Asian stocks to move down and stay down. The US recession has been foreseen and factors currently moving the market downwards are elements that have characterized the market for some time now. In such a case, the efficient market hypothesis does not hold good, especially in the wake of continuous downward recession. Conclusion From the study it can be concluded that credit crunch in an economy affects its corporate decisions along with the growth and progress of the economy. During credit crunch, interest rates in the economy are high. This makes the credit flow in the economy restricted as borrowing becomes expensive. Businesses maintaining steady credit accounts with banks and other financial institutions lose their credit facilities. This affects their business decisions and hinders their business flow. The housing market takes a hit during the credit crunch with housing prices plummeting and borrowers unable to meet mortgages or sell their property at low prices. Lenders are left with bad mortgages and unable to recover from them. Credit crunch also hinders entrepreneurship in an economy due to lack of availability of credit. The study has examined the credit crunch in the US as well as the European Union and how the crisis has affected the relevant economies and the global markets as a whole. The credit crunch faced by the US has long-term consequences for the Asian and European markets as well. This credit crisis has affected the dollar valuations, oil prices and gold prices, thereby, affecting the investment decisions of countries across the globe. References Clair, Robert T. and Tucker, Paula. Six Causes of Credit Crunch – Or Why Is It So Hard To Get a Loan? Economic Review – Third Quarter 1993. [Electronic Version] taken from http://www.dallasfed.org/research/er/1993/er9303a.pdf on April 22, 2008. Colombo, Emilio and Stanca, Luca. Financial Market Imperfections and Corporate Decisions. 2006: Springer Gillmann, Jan-Philippe, Heidegger, Helmut and Heidrich, Ralph. Coping with the credit crunch: Opportunities for corporate banking in Europe. The McKinsey Quarterly - March 2008. [Electronic Version] taken from http://www.mckinseyquarterly.com/Coping_with_the_credit_crunch_Opportunities_for_corporate_banking_in_Europe_2121 on April 22, 2008. Goodman, Peter S. Credit Crunch changes everyday life in U.S. International Herald Tribune – February 5, 2008. [Electronic Version] taken from http://www.iht.com/articles/2008/02/05/business/spend.1-217296.php on April 22, 2008. HepInvestor – Warren Buffet: Fed Decision won’t affect my investment decisions. September 18, 2007. [Electronic Version] taken from http://hepinvestor.blogspot.com/2007/09/warren-buffett-to-cnbc-fed-rate.html on April 23, 2008 Jubak, Jim. How far will the credit crunch spread? MSN Money – September 3, 2007. [Electronic Version] taken from http://articles.moneycentral.msn.com/Investing/JubaksJournal/HowFarWillTheCreditCrunchSpread.aspx on April 22, 2008. Lindgren, Carl-Johan. Financial Sector Crisis and Restructuring: Lessons from Asia. 1999: International Monetary Fund. McHugh, Robert, Ph.D. The Coming Credit Crunch. Financial Markets Forecast and Analysis - March 25, 2007. [Electronic Version] taken from http://www.gold-eagle.com/editorials_05/mchugh032407.html on April 22, 2008. Padmore, Elizabeth, Purdy, Mark and White, Lucie. Crunch Time for the EU. Critical EYE Review – December 2004 [Electronic Version] taken from http://www.accenture.com/Global/Research_and_Insights/Policy_And_Corporate_Affairs/CrunchTimeForTheEU.htm on April 22, 2008. Van den Heuvel, Skander J. Does bank capital matter for monetary transmission? Federal Reserve Bank of New York, Economic Policy Review – May 1, 2002. [Electronic Version] taken from http://www.encyclopedia.com/doc/1G1-87103985.html on April 22, 2008. Wolfson, Martin H. Financial Crisis: Understanding the Postwar U.S. Experience. 1994: M.E. Sharpe. Read More