Credit crunch and banking sector - Essay Example

Credit crunch and banking sector Chapter Introduction Credit crunch may be defined as a credit crisis caused by the incapability of the financial system to offer adequate liquidity to the demands of a developing economy. Credit crunch is marked by decreased corporate cash flows that lead to an increased demand for funds to perform the expenditure of companies, as in the case of a decrease in personal savings that will lead to an increased requirement for funds to run a household. Industrial and commercial loan growth slows down late during a crunch period because banks become gradually obligated to limit lending due to the slow growth rate of deposit and other obligations on bank reserves. Therefore credit crunch leads to decrease in the availability of loans to finance new investments (Wolfson, M. H., 1986 p.181). The objective of the research is to analyse the causes of credit crunch and its effect on the economy. Chapter 2 – Literature Review Credit crunch was a strange term for people in the UK. But the phrase has become common as the extreme shortage of credit or money has caused the cost of credit to rise sharply and has led the financial world to realize the seriousness of the situation. The root cause of the credit crunch had started earlier when the US interest rates increased from 1 percent to 5.35 percent during 2004 to 2006 that created a slowdown to the housing market. This was followed by the default in mortgage payments by individuals who could barely afford the payments even when they had to pay low interest rates. The rate of default on sub prime mortgages (high risk loans) offered to customers with no or poor credit histories increased to record levels and these defaults in mortgage payment had an impact throughout the financial systems because many of the mortgages were combined and sold to investors and banks around the world (Timeline: Credit crunch to downturn 2009). Recklessness in the economy for a considerable period of time is a major factor that causes credit crunch. A period of very cheap credit, low interest rates, irresponsible lending and rise in housing prices mostly leads to a tipping point when bad debts begin to emerge and credit becomes an expensive affair and price of housing tumbles paving way for a credit crunch. Credit crunch is a negative factor for business, especially for the banking sector because it is exposed to high levels of risk with bad debts. Low availability of capital and the decrease in consumer confidence can damages business across sectors. A serious credit crunch in the economy leads to an extremely strained credit and the institutions that cause the credit crunch finds it difficult to get over the economic condition. Easy and cheap borrowing becomes unreachable when credit crunch continues for a period of time. The credit crunch of 2007 / 2008 has happened as a result of issuing sub prime loan to poor credit borrowers in the early 2000. Large volumes of bad debts were bundled up and sold to international creditors thereby exposing numerous companies around the world to the sub-prime market. The increase in interest rates resulted in the decrease of house prices and the market immediately collapsed putting finance companies and the banking sector at large into serious risk (What causes a Credit Crunch? 2009). An analysis by Alliance trust reveals that banks in the United Kingdom have incurred huge write downs and have geared up funds to the tune of £20bn after the onset of the crisis. The banking sector is now facing deterioration in the quality since economies have slowed down around the world. Banks that relied upon UK market with a high loan to deposit ration is in a weaker condition than banks that have a global presence. Even after undergoing attractive valuation a vague picture prevails over the capital raising capabilities of banks. A market view report of Alliance Trust indicates that banks in the United Kingdom still possess comparatively low capital ratios when compared to their counterparts in North America, Asia and other European nations that have added to the ongoing uncertainty about the potential of well balanced balance sheet. The poor performance of bank in the slowing UK economy is attributed to the weaker housing market. However, all banks in the UK are not uniformly affected by the slow down. Banks that are domestically oriented are more exposed to the economic changes in the UK while global players like HSBC are not fully impacted by the credit crunch due to their stronghold in the Asian markets. But this condition will not last long since Asian economies are depended on the United States due to their huge export market. Hence the continuing slowdown in the American economy combined with the increasing inflation in Asian countries has an impact on banks in the UK which has economic interests in Asia. In these circumstances, the exposure of UK banks to commercial property is another factor of concern since some banks had been aggressive in boosting their exposure to commercial property in the recent past. But the focus of these banks was restricted to well let commercial property rather than risky investments and this is protecting these banks to a certain extent from the present volatility in the commercial property market. The view of the banks in the UK continues to be challenging and dependent on the stabilisation of the American and UK economies specifically the housing market of these two nations. Consolidation is a solution for small mortgage centric banks but prospective buyers are probably holding off till the economic condition stabilise around the world. The banking sector can tide over the credit crunch and result in better balance sheet figures by monitoring the strength of the banks liquidity position and capital and their exposure to specialist mortgage markets and commercial property where the prices are likely to weaken further (Alliance trust weighs outlook for UK). Chapter 3 Data analysis The credit crunch in banking sector began with the bankruptcy of leading sub prime mortgage lenders who filed for bankruptcy. Lenders who offered loan for customers with bad credit histories were worst hit by the downturn in the sub prime market. The developments that followed in the financial market is as follows: The downturn in the sub prime market was envisaged by the emergency financial support offered to the Northern Rock by the Bank of England to tide over crisis of one of the largest mortgage lenders of the UK. Though there was a notion that the bank was out of danger of going bust, it was finding it difficult to raise money to continue its usual lending activities after the money markets withdrew. It was an extremely rare decision for the Bank of England to emerge as a lender of last resort which was taken after consultation with the Financial Service Authority and the Treasury. The disclosure of this financial aid rocked the financial markets in the UK. Though the Northern Rock continued to be profitable, the financial aid indicated signs of financial crisis that was set to spill over to other business that had an impact on the lives of people in the UK. The lack of confidence among investors following the down turn of housing market in the US due to the distribution of loan to home purchasers with poor credit history evaded investors from purchasing all mortgage debt that included Northern Rock’s. Banks then faced a difficult condition where they could not mobilize funds from the market and even as a specialist mortgage lender Northern Rock could not generate funds due to its exposure to a greater extent of mortgage debt because its business was tremendously centered towards the provision of mortgages with no other banking business. Northern Rock was at the peak of its mortgage lending with 18.9 percent share of the net UK market in 2006. Later, the share of the firm was halved in value and became one of the greatest losers in the FYSE 100 (Northern Rock gets bank bail out 2007). The credit crunch in the banking sector was mitigated with the proposal of Bank of England to inject £10bn into the financial market to reduce the interests rates of inter bank lending. Though the proposed amount was £10bn individual banks could acquire only up to £1.5bn. However the Libor rate or the London Interbank Offered rate rose above the base rate of Bank of England which stood at 5.75% and short high of 6.75 percent which is the emergency lending rate. These developments indicated that banks were not willing to lend money to other banks due to the uncertainties in the financial market. The uncertainties were linked to the worth of various debts bundled from US banks which were instruments of sub prime mortgages offered to individuals with less income and poor credit history. The spare cash with banks were retained to meet their own needs and were unwilling to lend it to other banks. The creditworthiness of the banks that borrowed money was another factor that inhibited lending due to the extreme exposure to debts related to sub prime mortgage. In a bid to resolve the heightened credit crunch the European Central Bank was issuing funds to European banks to tide over the situation but at this stage the Bank of England was not willing to offer more funds (Bank of England in policy U-turn 2007). The down turn in the sub prime mortgage markets took a toll on the global stock indexes by tumbling the value of shares. Investors around the world required an ad-hoc plan to stimulate the US economy to avert further recession. Though the intervention of the government with tax cuts was aimed to improve consumer spending, the depth of the economic problems in the US did not make much difference to the spending measures and tax cuts. Even when banks were reassuring about their role in the US mortgage investments there was no change to the financial situation. Later, banks tightened their lending policies since the down turn of the US mortgage and housing market to save huge amounts of investments (Global shares tumble on US fears 2008). The head of IMF suggested that credit crunch can be tackled through government intervention from a global perspective. Though public intervention has been evident through the credit crunch to infuse liquidity in the markets including bailing out of banks, governments are required to take serious step to intervene in the financial system. The down turn in the housing sector and the concurrent down turn in the securities market can gain support only with government intervention. Additionally intervention in the banking sector would provide a third line of defence (Help needed for credit crunch 2008). Short term intervention The government has offered billions of pounds to bail out three major banks (Lloyd TSB, HBOS and Royal Bank of Scotland) in the UK through nationalization that ensures the government to have a say in the administration of the bank in return for the investment. . The investments made by the government in the banks are subject to sale at a later stage. The rescue package is aimed to assist the business and people of UK and boost the whole economy. The bail out of banks is an essential step to stimulate the money markets that have been in a frozen condition and offers short term solutions Long term intervention The government envisages long term policies by drafting new rules and new structures for the future. The investment reaps results not only in the short run but serves as a solution to the root cause and ensures that such financial crisis does not return. The government has taken long term policies by cutting the cash bonus of senior directors of banks for the current year and by ensuring that further bonuses will be paid in shared to encourage the bank management to take a cautious long term approach while dealing with money (UK banks receive £37bn bail-out 2008). Mid term intervention The government has enforced several strategies that will boost the economy in the medium term. Though these strategies increase the borrowing of the nation to record levels it is essential to save the country from long lasting and deep recession. The mid term rescue plan include high tax rates for top earners and more contribution towards National insurance. The VAT cut from 17.5 percent to 15 percent is balanced with higher duty on tobacco, alcohol and petrol. VAT cut is aimed to increase consumer spending to mobilize the economy. The government has also projected a negative forecast for the economic growth for next year from 2.75 percent to a minus growth between 0.75 percent and 1.25 percent. However, the government is obliged to pump in additional £20bn into the economy that equals around 1 percent of the GDP to stimulate economic mobilization combined with a large cut off in government spending. The loss through VAT cut is further balanced with an increase in top rate tax of 45 percent that will be implemented from 2011. The additional borrowing of the government is set to be balanced only by the year 2015/16. A short term and mid term action from the government will save the nation from long term recession and ensure cash flows in the economy at the most needy time and the rate of government borrowing can be reduced when the economy reaches a state of growth. The government has also taken measures to increase child benefit and generate financial assistance for small enterprises affected by the credit crunch. The excise duty for new vehicles has been increased slightly to encourage the purchase of vehicles. Home owners are also to benefit from a scheme that assures mortgage interest payments of people who lost their employment for mortgage up to £200,000 (Darling unveils borrowing gamble 2008). Chapter - 4 Discussion of the above data Schumpeter’s Theory of Economic Growth considers the fluctuations in economic development as a part of capitalism. According to him, recession is a self correcting factor in the economy which is beneficial to the economic system and forms an integrated part of the complete process of economic progress. Growth is related to the prosperity level of the cycle since it indicates maximum results from the introduction of novel technology and productions in the economy. However, excesses are formed as businesses overextend and credit becomes overexpanded. The depression that follows is beneficial because it trembles the economy and sheds the less efficient firms and prepares the opportunity for a developing economy comprised of well managed, healthy and efficient firms (Schumpeter Economics Theory and Growth 2008 ). Schumpeter’s ideology of creative destruction is applicable to the credit crunch of the banking sector. The unprecedented excesses in business and the over expansion of credit through reckless provision of loans to buyers with poor credit histories has paved the way for down turn which in turn has initiated economies to redraft the rules while providing loans to lenders thereby eradicating poor revenue generators in the economy and making way for high potential business. This conforms to Schumpeter’s ideology of creative destruction that enables the economy to innovate through better entrepreneurs and result in a progressing economy. Therefore the end of capitalism is an outcome of its success to generate more affluent economy (Schumpeter Economics Theory and Growth 2008). Adam Smith was against the importation of goods that could be produced at home because importation reduces the market for home produces and decreases employment. Similarly, the investment of capital in domestic market produces greatest possible returns and mobilizes the domestic industries and generates employment and revenue to a large number of residents in the country as against the capital employed in a foreign trade when there is equal profits. Therefore, Adam Smith requires individuals to invest capital domestically for equal profits from abroad because it supports the domestic economy and gives employment and revenue. The ‘invisible hand’ phrase explains how an individual’s investment in domestic market extends a greater reach in developing the economy with jobs and revenue without the actual knowledge of the investor because the gains of the investor is restricted to the return from investment but indirectly benefits the economy. Adam Smith also asks individuals to act in a prudent manner by importing goods that are cheaper than those available in the domestic market because it is profitable. Adam Smith adds that government regulation is important to give monopoly to the domestic market(Smith, A. 1776). Though Adam Smith encouraged free trade, he has laid specific emphasis on securing home markets from importation and discouraged the flow of capital into foreign markets when the investor can earn equal profits if invested in domestic market. The ideology can be reflected to the credit crunch where funds have flown to the US sub prime mortgage market through the purchase of bundled securities. The application of Adam Smith’s theory will reduce the unhealthy flow of capital which in turn can be fruitfully invested in domestic markets to create more business opportunities and employment and avoid risks such as the affect of global economic slow down. The credit crunch in the banking sector has a direct relation to Keynes theory. According to Keynes, it is the responsibility of the government to stimulate the economy when there is a deficit. Keynes holds the government responsible because at times of recession private sector will not make investments due to saturated markets, few jobs and reduced consumption. Therefore governments can avoid the economic issues or recession by acting in a responsible manner. Keynes appreciates government deficits (Reich, R.B. (n.d)). The British government has adopted Keynes theory by mobilizing the economy immediately by increasing the purchasing power of consumers and by injecting funds to banks to offer required credit to entrepreneurs and domestic consumers thereby reducing the impact of the economic slow down spurred by the down turn in the sub prime market. Further, the UK government has increased its borrowings to aid the ailing financial system immediately and envisages to balance the borrowing when the economy revives. Chapter – 5 Conclusion It may be concluded that the credit crunch has hit the banking sector to an unprecedented extent due to reckless selling of loans to customers with poor credit history. This may be considered as a normal phenomenon according to Schumpeter’s theory of creative destruction where the economy reaches a stage of over expansion and destruction is required to retain only fruitful business that will further boost the economy. The main reason for the credit crunch is due to financial investment in foreign bundled investments. The reconstruction of the economy should emphasis the need to signify domestic investment according to the principles of Adam Smith, while encouraging free trade to make a prudent financial choice. It is also the responsibility of the government to regulate the norms of foreign investment to save the nation from financial crisis. Once the crisis has occurred, the application of Keynes theory as proposed by the UK government by injecting funds into sick financial institutions and the adoption of policies to mobilization the economy revives the economy in the short, medium and long term. Reference Alliance trust weighs outlook for UK banking sector Available: http://www.alliancetrust.co.uk/press_releases/0069.htm. Accessed on April 26, 2009 Bank of England in policy U-turn 19 September 2007 Available: http://news.bbc.co.uk/2/hi/business/7002628.stm. Accessed on April 26, 2009 Darling unveils borrowing gamble 24 November 2008 Available: http://news.bbc.co.uk/2/hi/uk_news/politics/7745340.stm. Accessed on April 26, 2009 Global shares tumble on US fears 22 January 2008 Available: http://news.bbc.co.uk/2/hi/business/7199552.stm. Accessed on April 26, 2009 Help needed for credit crunch 7 April 2008 Available: http://news.bbc.co.uk/2/hi/business/7333948.stm. Accessed on April 26, 2009 Northern Rock gets bank bail out 13 September 2007 http://news.bbc.co.uk/2/hi/business/6994099.stmhttp://news.bbc.co.uk/2/hi/business/6994099.stm. Accessed on April 26, 2009 Reich, R.B. (n.d) His radical idea that governments should spend money they dont have may have saved capitalism Available: http://www.time.com/time/time100/scientist/profile/keynes02.html. Accessed on April 26, 2009 Schumpeter Economics Theory and Growth 2008 Available: http://www.economictheories.org/2008/08/schumpeter-economics-theory-and-growth.html. Accessed on April 26, 2009 Smith, A. 1776. An inquiry into the nature and causes of the wealth of nations Available: http://spartan.ac.brocku.ca/~tmulligan/3p82inv_hand.html. Accessed on April 26, 2009 Timeline: Credit crunch to downturn April 3, 2009 Available: http://news.bbc.co.uk/2/hi/business/7521250.stm. Accessed on April 26, 2009 UK banks receive £37bn bail-out 13 October 2008 Available: http://news.bbc.co.uk/2/hi/business/7666570.stm. Accessed on April 26, 2009 What causes a Credit Crunch? 2009 Available: http://www.mortgages.co.uk/credit-crunch/what-causes-a-credit-crunch.html. Accessed on April 26, 2009 Wolfson, M. H., 1986 Financial crises: understanding the postwar U.S. experience New York: M.E. Sharpe Read More