Center for Economic and Business - Term Paper Example

Global Credit Crunch - UK Economy The recent credit crisis which initially started to show its colors during the end of 2008 is continuing to play the spoilsport in the growth of world economy. It's been seven to eight months when we first heard of Lehman Brothers filing for liquidity. The root causes of present credit crisis could be summarized as the improper policy of successive governments that failed to check the financial institutions and mind gobbling schemes offered by various banks and financial institutions. The major causes could be termed as excessive liquidity, excessive lending, excessive leverage and excessive risk taking by the banks and other financial institutions. The global credit crisis posed a greater threat to UK Economy. It is estimated that almost 20,000 people will be losing their jobs alone in London's Financial Service Industry. The overall financial solutions to UK clients thus would be greatly affected. (CEBR, 2008)1 Therefore it is necessary to find necessary solutions to various aspects of present global credit crisis to strengthen the UK economy. Implications for Borrowing The global credit crunch has had the attention each and every human being for bad reasons. The present crisis has effected in job lay offs around the world mostly in the developed countries like USA, the UK, Japan, etc. As mentioned earlier, one of the root causes was excessive lending by the banks to the customers. In other words, the banks and other financial institutions lured the customers to borrow loan without any hassle such like low interest rates, 24 hours approval of loan, pay the installments after one year, etc. Such were the schemes offered by various banks to attract the wide range of customers mainly from housing sector.2 The banking authorities didn't even bother to check the liability of the person to whom they are lending, whether the person was able to pay back the money. The Bishop of London quoted in the Daily Telegraph that 'it is becoming clearer how far we have been mortgaging our children's tomorrow to fund our today, both financially and in our use of the finite resources of earth'.3 Looking at the past experiences of financial crisis occurred during the last millennium, it can be assumed that the process of borrowing from the financial institutions will be a Herculean task. The need to restore capital ratios and to recover the losses incurred, it is understandable the borrowers will have lesser flexibilities, less leverage, hike in interest rates and fees will soar at historical high. (John L. Moscione : p.6)4 The customers will have to face a strict scrutiny of their valuable documents before receiving loans as a process to identify previous lack luster performance by the bank officials. Implications for Lending The present crisis is the result of irregularities by the bank and financial institutions in providing loans to the customers without proper verification of their documents and checking the liability of the person. Excessive liquidity with the financial institutions was the foundation for excessive lending by the banks to rake in more customers. In a bid to acquire more customers, they offered lucrative schemes which were spontaneously grabbed by the seekers. Credit crisis was inevitable in view of real estate market boom in recent years which blew the bubble by way of irregular mortgages, unverified loans without scrutinizing the income or assets of the borrower. This facilitated borrowers to indulge in fraud and leveraging of accounts. Most of the loans were approved on the house mortgage which was another cause for real estate boom all over the world. Selling and buying of houses were on spurge, with rates touching the all time high. According to statistics from the Bank of England, total net lending to individuals in January 2009 was 1.1 billion which was lower as compared to December 2008 that stood at 2.1 billion. The total net lending secured on dwellings was 0.7 billion in January 2009 as compared to 1.8 billion in December 2008.5 It is learnt from the facts and figures derived from Bank of England, that lending has drastically come down as a result of present credit crisis. Stern measures have been taken by the financial institutions before the lending process to any individual. Effect on the regulatory environment The credit crunch would not have been possible without the golden hand of irresponsible government authorities. Prominent economists did already warn the federal governments in 2007 itself about the coming monster, but their warning was not taken seriously. It all started with New Century Financial, specialized in sub-prime mortgage, filed for bankruptcy in April 2007, which led to collapse of many financial institutions around the world.6 Aftermath of credit crisis, different Federal Reserve stressed on changing the monetary policies to bail out the financial institutions from the crisis. The UK government announced a temporary cut in the level of VAT to 15% from 17.5%. The Bank of Englandslashed interest rates from 4.5% to 3%- the lowest level since 1955. The UK government announced plans to pump billions of pounds of taxpayers' money into three UK banks inone of the UK's biggest nationalizations.Royal Bank of Scotland (RBS), Lloyds TSB and HBOS will have a total of 37bn injected into them.7 The UK government launched the bail out plan by extending 400 bn to eight of the UKs largest banks. The credit crunch has affected the government and Federal Reserve policies. Effect on profitability and long-term viability Using the U.K implications, it's prospected that the wider U.K economy will have a slower prospected growth. The consumers, like those of the U.K, are experiencing hard times over the entire globe. The resulting low growth rates if the economy may lead to high taxation rates as well as inflation in the process of the government's seeking to cover deficits of tax revenues. Those governments with big government expenditure plans are bound to experience the same. For instance, the forecasts have it that budget deficits are likely to be continually felt in the uncertain period in future. The deficit of the budget is set to rise further still. The overall result is to feed the already high levels of inflation to growth further. The impact on the sector of finance is that it is experiencing very high drop rates in the profits that are taxable in the UK. Consequentially bad debt provisions are called for to be higher. (Walayat, 2007)8 Effect on the actions being taken by governments To resolve the credit crunch crisis the government can restore to the financial intermediaries, their previous roles. Of complexity is the restructuring of the financial processes to raise money to restructure programmes. Principally it's the task of the institutions of finance to ensure the funding of the financial restructuring process. (Hooley, et al 2002 p 477)9 The governments, like the US government, can have a bail out plan. The plan involves cases like where the U.S government floated a proposal of U.S $ 700 billion to purchase toxic assets held by the country's biggest banks. This move would help to restore the financial system's confidence. An amendment to the set out plan was made, limiting on the pay to executives as well as an option of the same government taking stakes in the corporations that are going to be bailed out. Nevertheless, the actions by the governments can lead to a spark in negative views depending upon the economic set up. For example, many people argue that the move to bail out banks by giving them the funding by the government may amount a communism way of governance. Analysts, though, view the government's bail out plan as a short-term source of aid. Regulations of the financial sector are also called for by the Federal officials. On the other hand, through the government, banks of Europe and England made heavy investments in the mortgage-securatised securities being offered by the Wall Street market. One German government's move involved a guarantee to all private savings accounts across the nation and also a bail out plan was set for the biggest lenders in Germany as well as the main European company of finance. (New york Times, 2009)10 Impact if deflation / depression takes control Deflation is often seen as falling price levels. However, deflation should not be confused for depression. Confusion sets in because decline in prices is an economic progress, where there is a rise in production and commodities supply causing a price decline. Deflation is related to the fall of business profits and a higher hardship in debts repayment. (Reisman, 2003)11 Economic depression is defined as a long period of an economy's downturn or recession. The characteristics that signify an economic depression may include; failing activities of the business, escalation in unemployment levels, price falls, and rise in the levels of inventory, panic and public's fear. However, the definition is not final since economists still have not reached on a conclusive and single definition. (Yourdictionary.com, 2009)12 IMF claimed that the credit crisis that hit the U.S is the year 2008 was not a U.S case, but a case that's going to affect many nations globally. The downturn of the world economy may have an uncontrollable inflation going tandem as well as a fall in the output worldwide. The forecasts are that the depression situation witnessed in the 1930's could haunt the world a gain. The IMF also said that the US's housing slump and the credit crunch is the highest concerning financial inventories since the 1930s. The IMF predictions had it the U.S economy would grow at a very low rate of 0.5% in the year 2008, which signifies the worst level since 17 years ago. Globally the economy of the world was set to grow at 3.7% in 2008 compared to 2007's 4.7%. The IMF forecasted that the economies of Britain, Germany, France and Canada would have a slowdown in 2008 and after years. From the point of view of these mentioned countries, a small contraction can have the world economy and falling. This is due to the fact that they constitute about 30% of the world's GDP. Investors are aware of the recession. Further still, unemployment rates have increased. Signs of recovery were not there by summers. From these points and recession definition being a fall in a nation's real GDP or a real economic growth that's negative for two quarters at a row. A scenario of depression is a possibility since it's only but the worst case of a recession. (Pickford, 2008)13 Effect if government and the Bank of England gets their response wrong Only through the government, does the bank of England execute its actions toward controlling economic function of the UK. For example, recently in 2009 the monetary policy committee of the Bank of England voted to call for the government's permission to raise the money supply levels in the economy. Thus, the final authority toward solving the credit crunch lies with the government. (Telegraph staff, 2009)14 If the Bank of England and the government fail to make an apt response to the credit crunch crisis, IMF comes in. It's called the International Monetary Fund and assists in effective adjustments economically by use of various programmes. IMF promotes financial stability internationally and the adjustments called for externally. The government can therefore, seek aid from the IMF. The role of the IMF encourages the necessary adjustments as well as restoration of situations of creditworthiness. They make the essential conditionality and help to maintain the conditions' effectiveness in the globe's financial and economic systems. IMF stresses the availability of credit and which must be sufficient to aid members. It also catalyses lending by its provision of confidence- that borrowers of funds are seeking policies that are sound. (Crocket et al 987, p 59)15 Financial Institutions Bail Out Kunzemann an author from Pakistan argues that the credit crunch had not affected the microfinance institutions at any extent as per the early 2008. There's influx of funds both from equity funds and private investors. In fact there is a boom in the micro-finance business. The global microfinance market is expected to grow about ten times by the year 2015. However, it's a fore warning that the growth in money levels may create problems in future. Although major banking institutions in the world have experienced some of the worst times, microfinance sectors continue experiencing a heightened expansion rate. One of the Pakistani managers of microfinance says that the business of microfinance is highly diversified. For example, a microfinance institution called Dutch Oiko credit entirely depends upon its funds for own capital. Up to 2008, the microfinance institutions had not had any changes recorded due to the global credit crunch. Bibliography 1. Bank of England. Lending to Individuals January 2009. 2 March 2009. http://www.bankofengland.co.uk/statistics/li/current/ 2. Center for Economic and Business Research, 24-7 Press Release, London, UK. 3. Crockett, A. et.al. (1987). Strengthening the International Monetary System: Exchange Rates, Surveillance, and Objective Indicators. International Monetary Fund. p 59. 4. Hooley, R.W. et al. (2002). The Post-financial Crisis Challenges for Asian Industrialization. Emerald Group Publishing. P 447. 5. http://www.telegraph.co.uk/finance/economics/interestrates/4688047/Bank-of-England-seeks-power-to-inject-more-money-into-economy-to-fight-recession.html 6. Implications of financial crisis and the recession (2009), http://www.cofe.anglican.org/about/gensynod/agendas/feb09/gs1719.pdf 7. Jos D. Roncal, Jose D. Roncal and Jose N. Abbo, Jose N Abbo (2008) The Big Gamble: Are You Investing Or Speculating, Wheatmark, Inc 8. Miscione L., John. The Current Credit Crisis and its implications for ESOP Companies.The Journal of Employee Ownership Law and Finance, Vol.20/4. NECO. p.7 Pickford, S. (2008). Worldwide Depression: A Real Possibility. Retrieved February 28, 2009 http://www.politicallore.com/economy/worldwide-depression-a-real-possibility/218 9. Reisman, G. (2003). The Anatomy of Deflation. Retrieved February 28, 2009 http://www.capitalism.net/articles/Anatomy%20of%20Deflation.html 10. The New York Times. (2009). Credit Crisis-The Essentials. Retrieved February 28, 09 http://topics.nytimes.com/topics/reference/timestopics/subjects/c/credit_crisis/index.html 11. The telegraph staff. (2009). Bank of England Seeks Power to Inject More Money into Economy to Fight Recession. Retrieved February 28, 2009 12. Timeline: Global Credit Crunch. BBC News. 23 February 2009. http://news.bbc.co.uk/2/hi/business/7521250.stm 13. Walayat, N. (2007). Impact of the Credit Crunch on UK Borrowers Debt Mountain Going into 2008. Retrieved February 28, 2009, http://www.marketoracle.co.uk/Article2734.html 14. Yourdictionary.com. (2009). Definition of Economic Depression. 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