Factors That Lead into Development of Credit Crunch - Essay Example

Abstract This paper reports on factors that lead into development of credit crunch. Three factors are assessed in order to determine their influence in creating a scenario for decreased lending of financial institutions. First, financial institutions accounting practices are evaluated with respect to factors that predispose credit crunch and strategies that financial institutions impose in order to quench credit crunch from becoming a chronic incidence that may lead to collapse of financial institutions, markets and trading. Potential of marking-to-market of mutual funds and securities, formation of collateralized debt obligations and subprime bonds are evaluated and their potential to future sustainable profits and predisposition of financial crises determined. Second, structural factors that define conceptual framework are evaluated on the basis of fair value accounting and degree in which financial institutions are aligned to comply with specifications of conceptual framework. Institutional factors that affect sustainability of profit, via efficient financial reporting tools are analyzed as well as weaknesses associated with use of conceptual framework in financial accounting. Third, economic value as a parameter that affects sustained profits and how it positions institutions to deliver value to its stakeholders by working towards profit focused strategies, value proposition and trade offs has been evaluated. It has been found that poor financial reporting; poor accounting practices and prevalence of operational deficiencies are main factors that easily trigger credit crunch. This means, fair value accounting that is a product of conceptual framework triggers financial crises because credit quality of a financial institution cannot be determined if the financial information is not relevant, reliable, comparable and consistent. In theory, conceptual framework has values that could lead into good financial reporting and accounting practices but its application is limited its weaknesses. There is therefore a need for revision of the conceptual framework. Introduction Credit Crunch1 is an immediate financial incident that is characterized by reduced availability of loans from banks that brings about an increase in the cost of securing a bank loan2. Banks make the cost of lending money difficult when there is expected future decline on collateral used by the bank to validate issue of a loan3. Credit crunch can also result from perceived risk of solvency of other commercial banks in the banking system. Credit crunch can also be triggered by changes in the monetary markets that force central banks to increase interest rates or reserve requirement. Changes in interest rates of central banks can also occur as a result of central governments having direct control or issuing instructions for banks not to engage in monetary lending activities Background of credit crunch According to Dewey (1938) credit crunch arises as a result of sustained inappropriate monetary lending that consequently leads into losses and increase of serviceable debts. The lending institutions increase conditions for credits by setting higher interest rates and thereby increasing cost of accessing credit facilities. Dewey (1938) argues that monetary losses can make institution to stop further loan advance to institutions. Kaplan and Norton (1996) suggests that in the event of credit crunch the lending institutions re-strategize and re-position themselves and go to liquidation especially if capital for the continued sustainability of business is not enough to see the institution through the credit life cycle. This stimulates inflation and can predispose collapse of the financial institution if there are no measures in place to rescue it to financial economic activity Statement of problem The main cause of credit crunch is not inappropriate leading practices or poor financial management but poor accounting standards and procedures4. investors with mutual funds whose assets do not have a ready market like mortgage securities5, corporate debts and venture capital investments mark to markets by making comparisons of likely factors that might be used by market participants in pricing assets and liabilities. Formation of subprime bonds and collateralized debt obligations that have no long term trading history predispose marked credit crunch. In the event of credit deterioration, market participants write down value of the assets and gradually or instantaneously buyers decrease to nil. Objectives of studies on Credit Crunch The objectives of the studies on credit crunch is to analyze the conceptual framework with respect to accounting practices; to determine processes that are involved in regulating financial reporting as a subset of prevailing accounting standards, to determine effectiveness of financial statements as a function of relevance and reliability, to evaluate relationship between historic value and current costs as functions of accounting. Theoretical background of credit crunch and financial accounting Economic value is defined as the difference between the cost and the price and is measured by sustained profit. A financial institution’s current stock price is not a measure of its economic value; the long term sustained profitability and shareholder value are convectional measures of economic value. Stock markets are generally fragile and investors lose the value of their investments through decreased earnings. Recurrence of decreased earnings discourages further investments and consequently diminishes financial institutions efforts to uplift its financial performance by offering innovative value, adding products and services that could have an effect of improving its share value and share trading potential. Significance of studies on credit crunch The studies on credit crunch will help in development of a financial accounting system that has provision for feasible risks and returns suitable for different types of investors and that is in line with accounting ethics and accounting profession standards. The studies will help in streamlining of hedge funds that will make investors with high rates of returns to better understand risks that are involved. The studies will recommendation of establishment of collateralized debt obligations that will serve as a potential background for discussion on issues of accounting standards Theoretical framework of credit crunch A financial conceptual framework according to Shields et al. (2006:313-334) is theoretical guidelines that facilitate accounting research and looks into definition of an accounting problem6, objectives of the financial reporting and accounting7, review of literature on financial principles and practices, methodology of carrying out objective financial accounting practices based on monetary principles, data collection procedures and analysis of financial data in order to justify objectives of study. A financial conceptual framework as reported by Shields et al.(2006) plays the role of a map8 that provides coherence to empirical inquiry. Since a financial conceptual framework is potentially similar to empirical inquiry, a financial conceptual framework reorients its baseline9 depending on the accounting problem in question. Shields et al. (2006) reported existence of different kinds of conceptual framework that included working hypotheses conceptual framework, descriptive categories conceptual framework, practical ideal-type conceptual framework, models of operations-research conceptual frameworks and formal hypotheses conceptual framework, all of which are applicable in different fields of public, accounting and financial administration settings. Each of the conceptual frameworks is used for a particular type of research purposes that may be exploration, description, gauging, decision making and explanation or prediction research. After conceptual objective (Kieso n.d.) and conceptual framework are determined, other supportive or auxiliary aspects of empirical research such as choice of methodology that includes survey, interviews, analysis of existing data or primary data, direct observation, use of focus groups and particular type of statistical technique become predictable. Shareholders expectations Haspeslagh et al (2001) observed there is great global pressure on financial institutions to deliver superior value to their shareholders regardless of their corporate or cultural heritage. This is partly due to increased competition, globalization of capital markets and presence of an increasingly active and powerful institutional class of investors that demand unequalled performance from corporate executives10. Therefore, delivering shareholder’s value has become a kind of mandatory performance target for senior financial executives across the globe. Collins and Montgomery (1998) reported that following evolution of capital markets in 1980, opportunities arose for revitalizing under performing financial institutions11 that gave rise into corporate raiders and as a result, financial institutions began to focus their attention on market valuations of their stocks as opposed to historic costs12. The demand imposed on financial instutions by new corporate governance procedures that required transparency and accountability in accounting standards, made the situation worse for the leaders, lenders and borrowers who expected high value optimization13. Prescription for optimizing profitability and shareholders value Financial institutions operate as open systems and therefore their financial successes and achievement are a function of financial activity taking place in their external financial markets environments. Johnson and sholes (1993) claims if a financial institution is to sustain her economic value, she has to match her external financial market environment and in particular, her market’s and customer’s expectations of increasing value creation. Consequently, financial institutions are supposed to deliver worth, characterized by increased value to their shareholders and this has potential to stimulate the need to seek better prescriptions of optimizing profitability and Economic Value Added (EVA). EVA compares profit with cost of capital employed, and is arrived at by deducting from the annual profit an estimated or assumed cost of capital. This translates EVA as a residual value or profit above the cost of capital There are two factors that determine profitability of a firm namely its structure that determines profitability of average competitor and sustained competive advantage that positions a financial institution to out perform her competitors. A sustained competive advantage is achieved by operational effectiveness and strategic positioning of the financial institution by being profit focused, defining unique value proposition and trade off of what to do and what not to do. Some of the prescriptions of optimizing profitability include strategic planning, back to basics criterion, emerging strategy analysis, logical incrementalism; return to the core business, sticking to the knitting rules and embracing an attitude of putting the customer first prioritywise. It is only financial institutions that create increasing EVA that will retain support of their shareholders. Ansoff and Sullivan (1993) argued that there is no financial institution that is going to survive impacts of credit crunch by virtue of her historic and build successfully her future on historical strengths. Porter (1995) reported that a development of competitive advantage reguired adoption of three basic generic strategies that are effective cost leadership and cost management, competent differentiation of financial products and focus. A focus strategy is a product of effective cost leadership and cost management and competent differentiation of products in a niche market. Reisner (2002) proposed that financial firms can improve their EVA performance by ensuring there is connection between change intiatiatives and core business. Secondly, recognizing incremental improvement is not strategic transformation although it leads into profitability and increase of EVA in the short term. Thirdly, by setting anticipated realistic limits of performance. Fourth, by developing and implementing strategies, introducing change initiatives at the right time, with the right focus and implementing strategies with minimum market resistance. Kaplan and Norton (1996) prescribed Balanced Scorecard (BSC) for financial institutions to ensure correct focus on key areas that drive performance in order to create Economic Value Added. These success factors for creating shareholders value are measures of financial, customer, internal processes and learning and growth pespectives Many financial institutions that have prescriptions for optimizing profitability and increasing value creation have used diversification and portfolio management. Effective diversification is backed by acquisition of new synergic units or products or services and this is achieved through internal configuration, integration and development of strategic alliances. Portfolio management on the other hand places a financial institution to engage in more than one unrelated business line with key aim of managing synergic income, profit and value creation risks hence having a quarantee of stable profits and maintaining value for its shareholders. Collins and Montgomery (1998) reported that financial instutions diversify because of two main reasons that are external inducement characterized by opportunities in the financial firm’s external market environment and as a response to internal inducement mainly to take care of excess financial capacity. Discussion It emerges that credit crunch is a function of prevailing current financial crisis that are subject to application of fair value accounting. This implies that credit crunch is a financial market response to lack of isostatic equilibrium of forces that affect accounting practices and is triggered by demand for better value based accounting standards and practices14. Credit crunch is therefore a resultant of accounting standards that demand financial instruments and securities to be lesser marked to market. The effect of credit crunch is characterized by increased inflation especially in mortgages securities. The reason for prevalence of credit crunch is adoption of fair value accounting procedures that require entities to be based on assets as value function derivatives and other financial instrument to mark to market prices. This is in line with a mixed attribute model that allows use of historic cost principle, fair value principle, lower of cost or market and other valuation bases models. The fair value accounting protocols embrace use of fundamental concepts and are backed up by qualitative features that make it possible to determine variations and degree of variants between useful accounting information and inferior accounting information. The fair value accounting model has primary and secondary characteristics that define essential features of financial reporting. The main primary features are relevance, reliability, comparability and consistency. In terms of Reliability, the financial information should reflect the truth regarding the scenario for those who have no time to cross check the financial information and for those who are not able to verify the financial information. The financial information should have verifiability features. There should be potential of arriving at the same conclusion when similar information is presented to different evaluators or users of the financial information. The information should be backed by relevance characteristics in that any user or evaluator should be able to make a difference in financial decision. The relevance of the information should have a prediction value in order to facilitate prediction of past, present and future financial transactions. The financial information should assist user or evaluator to confirm or correct expectations before hand. This means the information should have potential of feedback value features. The account frame work should be a function of cost benefit, materiality, industry practices and conservatism. By virtue of fair value accounting, credit crunch develops from deviation from relevance and reliability of the financial information. Relationship of financial accounting and fair value accounting The fair value accounting is characterized by financial instruments that have different levels of risks and returns that are tailored for different types of investors. These financial instruments often cause problem to the entire financial profession and can easily distort the primary characteristics of conceptual framework that are relevance, reliability, comparability and consistency. Financial instruments are used for determination of hedge funds with sole aim of reducing degree of risk and speculation. There are problems that are characterized by inadequate measures of hedges and speculations although their accounting methodologies are different. This predisposes complexity and confusion especially for regulators and accountants for financial instruments as well as auditors. Hedge funds encourage investors with high rates of return when the investors do not understand the risks involved. The overall objectives of the IASB The primary objectives of IASB is to develop accounting standards that satisfy criteria for high quality, transparency and comparable information in financial statements as well as ensuring financial reporting adds value to participants in the world’s capital markets and enable other users to make informed economic decisions. Secondly, to promote the use of financial standards and lastly, to converge national accounting standards and International Accounting Standards Limitations of conceptual framework Conceptual framework has short comings. Conceptual framework lacks a basis of general theory permissiveness of accounting practice and general inconsistency of accounting practices. Conceptual framework does not have security of tenure and is subject to political interference. Analytical benefits of conceptual framework In the light of accounting, conceptual framework is a structured theory that forms basis for recommended scope of accounting practice and financial reporting. Conceptual framework identifies itself and subscribes to definable qualitative characteristics of financial information that are relevance and reliability of financial information. The operational level of conceptual framework is dictated by principles and rules of recognition and measurement of the elements of financial statements. Therefore, theoretically, conceptual framework is a coherent system of interrelated goals and fundamentals and is expected to be governed consistently by standards that should reflect the nature, function and limits of financial accounting and reporting. The positive outcomes that should be derived from conceptual framework should satisfy consistency, logical reporting specifications, financial accounting and reporting compliance, enhanced accountability, improved understandability of reporting requirements and better economical standard setting. For all practical purposes, the benefits that should be derived from conceptual framework are not realized. Thus, failure to adhere to conceptual framework procedures for accounting and financial reporting distorts the value of accounting practice and predisposes uncertainty in the capital markets that react through inflation of pillars of financial institution collateral, the mortgage securities. Therefore, fair value accounting is to blame for incidences and prevalence of credit crunch. Bibliography Dewey, John. Logic: The theory of inquiry. New York: Hold Rinehart and Winston, 1938. Kaplan, Abraham. The Conduct of Inquiry: Methodology for behavioural Science. Scrantum PA: Chandler publishing Co., 1964. Kieso and Weygandt. Intermediate accounting:the conceptual; framework of accounting chapter two. ninth edition. John Wiley and sons,Inc., n.d. Shields, Patricia & Hassan,Tajalli. "Intermediate theory: the missing link in successful student scholarship." Journal of public affairs 12, no. 3 (2006): 313-334. Read More