The causes of the 2007-8 Credit Crunch

A credit crunch is a phenomenon where by banks become unable to access funds. The current credit crunch originated from the United States and spilled over to the United Kingdom and other nations. It was caused by the sub-prime mortgage in the financial system of the United States. The housing recession in the United States turned into a major problem which caused a full-scale credit crunch that was passed over across the global economic system. Central banks of the affected economies have turned to a range of measures to revert the financial difficulties. However, these interventions failed to solve the original problems that were entrenched in the unfettered operations of the global fiscal system and its connections with the global economy (Fang Z. 2005L: 26-31).

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The Federal Reserve of the United States failed to provide reserves to banks which had declining deposits. This led to extension of the banking crisis in to a major problem internationally. Financial crisis in the United States began back in 2007. Early in the year, there happened to be an excess of residential houses for rental purposes in the United States. This led to a drop in their prices. The time for loan repayment by the loaned to the respective banks was due and they had to start submitting their monthly installments. This came at a time when rental prices had come down, with many customers unable to reinstate their mortgage. This caused banks to face a difficult time after customers failed to repay their loans. The expectations of house owners dwindled, and many of them had to turn to other means of earning income as the houses were unable to fetch anything substantial as anticipated. There was a rise in the number of discarded mortgages which were viewed by customers as an additional burden, for the fact that they cost monthly payments that were higher than the net worth of the houses.

Many banks suffer because of the Credit Default Swaps have unreal values, while the amount of claims owed to a great extent surpasses the number of bonds. The situation of the banks is not at its best. More over, the use of the accounting for fair value is problematic. Financial institutions are required to ensure that their asset value is measured against the existing market prices. The problem presented by this measurement is that the price can be more than the value of the presumed asset especially when the prices of buyers are extremely low. In such a case the institutions become troubled. Some banks have also suffered most due to the credit crunch due to the risk of dealing with an affected partner in the banking system. An example of such is presented by the case of Bear and Stearns which was offered emergency liquidity by Fed. Bear Stearns was facing problems with the Credit Default Swaps which had high interest rates. This has played a role in raising the leverage of many banks facilitating the downturn as well as heightening the bust.

Many banks as well as other monetary institutions weighed down on liabilities in order to raise their proceeds on equity whilst asset prices began to rise. They became vulnerable to product leverage through multifaceted structures like the Credit Defaults Organizations that could suffer hefty losses because of a minute weakening in the price of fundamental assets. The banks and the financial institutions also took more than enough towards liquidity leverage, with the use of prearranged ventures or relied on wholesale markets excessively to take advantage of the difference between having a loan of inexpensive short-term money and investing in the long term for higher value assets. The collective effect was that deterioration in the value of the assets affected equity largely. At the same time, they generated margin calls from lending institutions. The drop of liquidity had an instantaneous effect since the frequency of rolling over debts was relatively high.

The impact of the credit crunch is harsher on investment banks. Profits have been reduced significantly by the credit crunch. This may lead to customers withdrawing their money while the external financers withdraw the funding. Lack of confidence in the institutions has even affected the strongest banks since the lenders usually tend to call back the money it owes more quickly than the money the bank is owed by borrowers. The major tool that a bank can use in order to maintain the confidence of lenders and its customers is to assure them that their money is readily available whenever needed. Banks suffered severely because they could no longer keep this confidence as it was evident from the credit crises that the banks were loosing liquidity. With some banks collapsing and customers in other banks learning that the fate of their money would be compromised, they tended to loose confidence and could no longer deposit their money in these institutions.

Banks are significant in the economy in the sense that they drive it through apportioning and financing flows of credit to enhance the use of capital as effectively as possible. That progression happened in the reverse. The capital base of banks narrowed as write downs have affected equity and caused a dire need to reinstate their capital proportions to health to satisfy supervisory bodies and to restore confidence in customers and lenders. Many banks have resorted to reducing the size of their balance sheet through giving up some assets or by reducing their lending. They have become vulnerable to failures of governance. This is because their system is difficult and exposed to high risk which makes them complicated for shareholders to preside over. The complexity of the investment banking system as well as the complications in their earnings is hard to understand. Banks have a culture of being a causative factor. They are responsible for the crisis which is mainly triggered by their level of turnover, which leads to the deterioration of institutional planning in regard to earlier experiences. Intensity of product improvement is quite high, meaning that a lot of products come under minimal stress.

There has also been the problem of many banks failing to retain talented managers. The high turnover level of workers has largely contributed to the adverse effects of the credit crunch in many banks. Blame game and inside politics towards the responsibility of credit managers over the credit crises has led to a reduction in the group of the talented managers who could assist to solve the problem due to their experience and knowledge. Some banks clearly also underestimated the risks of illiquidity. Most of the banks were unsuccessful in predicting the chances of failing to maintain liquidity hooked on the cost of domestic funding for traders. Banks are prone to market losses due to an increase in the capital charge that the banks had lowered through provision of illiquid commodities in their operation books to draw a lower capital charge.

Cautious banks were organizing in-house assessment models regardless of the evidently observable market prices. These were able to plan proper disclosures on sizing up of the markets, compared to those who had no internal valuation models. Even though many banks have suffered a lot due to the credit crunch, there are some banks, mainly in Europe, that have persistently kept up their bonus payments all the way through the crisis, in spite of appeals from supervisory bodies to cut dividends and give attention to restoration of capital levels. Banks that turned the cash flows from a group of fundamental resources like mortgages into bonds in order to make the monetary system more flexible were faced by many problems. This process of securitization resulted in writing off sub-prime mortgages.

By allowing access to a greater pool of capital, securitization contributed to the lowering of the cost of mortgages making the ownership of houses more inexpensive for customers without sound credit record. This led to excessive house ownership leading to reduced profits for the house owners. The borrowers became unable to repay their loan and banks had to bear the losses. Securitization corrupts credit value by deteriorating the banks’ motivation to keep an eye on the quality of the loans they write. Banks were keeping every loan until it got to maturity while risks were sold and extended among a wider collection of banks. It is evident that the banks suffered most because of securitization. Securitization made banks unable to distribute risk efficiently. The risks streamed back to the banks as lethal assets. Some banks suffered most because the loans had not been sold off to investors. These could have taken the position of risk absorbers. They were hindered from playing this significant role by fair charge securitization.

 

Whilst the large financial lenders are trying to cope with the losses incurred through sub-prime mortgages, small scale banks reserved their conservative way of operation and never participated in the lending frenzy. With the original financial panic lessening, many banks are undergoing a phase of reduction of expenditure and restrain. Some conservative banks are at an advantage over other competitors, due to the weaknesses brought about by the credit crunch. The Islamic banking segment is one of the financial systems that are doing relatively well while other banks are facing the credit crunch. The banks will be significant in the financial system. Other banks that are not hampered by government intervention especially in the Middle East region have an advantage of expanding. This is because they have not requested for government funding before. More over, there is a possibility of several banks from the United States that have an opportunity to grow in the Middle East region even after suffering heavy losses in their domestic markets.

Several large international banks are also properly oriented in expanding their market share as many others have their efforts suppressed by the credit crunch. The Islamic banking sector will take advantage of the credit crunch. This is because they were not involved in the lending that brought financial crisis in many of the banks. This is because the kind of investment that they can venture in has restrictions from the Sharia law. These restrictions had made them unfavorable to borrowers due to their high rates. However, the banking sector has changed, there by accommodating more deals with foreign companies than before. The banks therefore have a competitive advantage of expansion in the existing banking difficulties. They mostly depend on small scale funding, making them less vulnerable to changes in the liquidity of external banks as well as the capital market. In the current condition where conventional banks are facing financial difficulties, the Islamic banks tend to utilize the opportunity presented by reduced competition in the financial market. According to Fang Z. (2005: 46-51), “The balance sheets of Islamic banks are strong, which strengthens their competitive advantage in the financial system.” This strength keeps them ahead of other convectional banks as well as firms that are always striving to lessen the level of their debts. Fang Z. (2005: 55) further states that, “The convectional banks are undergoing a process of global de-leveraging.” This is a process of reducing the debts owing. The Islamic banks have a strong capital base with few debts. The high cost of funding in convectional banks is leaving them susceptible to risks and with reduced competence in the financial system.

Other banks such as the Bank of Canada are experiencing normal growth, which according to Geoffrey (2004: 22), is expected to grow at a similar rate as that of the last 12 months. Due to the progress in the non financial sector of the economy, Canada is experiencing improvements in employment. Consequently, the demand for housing has increased, thereby supporting the mortgage ventures. This will have a positive impact on loan repayments. The Bank of Canada has made a resolution to reduce the interest rates which also has a positive impact on mortgage rates. There is a significant drop in inflation, thereby giving the Bank of Canada freedom to take insurance against recession. With an average drop of inflation by 1.4 percent annually, the stability of the bank of Canada is guaranteed. The bank has plans to input further finances in order to evade any chances of vulnerability to global recession as has been predicted by the IMF (Howard 1999: 76-78). Chinese banks are also doing relatively well. They have an advantage of not being part of the international financial system. China’s economy is developing at an impressive rate. The country has become a major supplier of manufactured goods to many external markets including the United States. It has been able to maintain high foreign trade reserves, which are used to buy securities from the United States such as treasury bonds which assist in the averting inflation (John 2001: 16-21).

Russian banks on the other hand are not faced with credit crunch problems. This could be attributed to the revenues earned from oil reserves. The country’s federal government supports the financial system. This helps the banks to evade downturn that may be caused by the credit crunch. With the experienced gained from the liquidity crisis that the banks experienced when money was withdrawn from banks by depositors in 2004. This occurred as a result of allegations that the banks with licenses that had been withdrawn by the Central Bank. The country had enough foreign reserves as well as the oil stabilization fund that was used by the government to improve liquidity in domestic banks rather than opting to seek assistance from IMF. The government assisted domestic institutions to repay foreign debts. The government loans have helped the banks to repay foreign debts. They are therefore expected to continue doing well in spite of the current credit crunch (Charlie 2007: 18-25)

There has been an improvement in the confidence amongst domestic banks in Russia after the crisis in 2004. The confidence of customers was also improved by the system of deposit insurance. The high foreign exchange reserves ensure that the Central Bank of Russia is capable of financing the Russian banks.  The Central Bank of Russia helped to avoid a recurrence of the 2004 bank crisis through introduction of 10 billion dollars in to the financial system. It also brought in ways in which to augment bank’s financing through the euro bonds which had previously been dominated by ruble bonds.

The dependence on foreign banks in many domestic banks has been a major drawback in their endeavors to evade the economic downturn. The foreign banks have been helping in external deficit financing as well as growth of domestic lending. This becomes a problem when foreign banks fail to put in more finances. However, there are some banks in various countries that do not rely on foreign banks to finance local lending. Iceland is one of the countries where dependence on foreign lending is not practiced. The subsidiary banks borrow from their foreign parents especially from West Europe where many of them are based. There has also been merges between banks that make them reap sustainable profits (Charlie 2007: 33-37). Due to this the banks have been able to do progress relatively well despite the current credit crunch. The same case applies to Pakistani banks.

 

 

 

 

 

 

 

Bibliography

  1. Charlie S. (2007) the Credit Crisis: an Overview of Development, 2nd edition, London:     Century Business.
  2. Fang Z. (2005) “Entrepreneurship and Innovation” Journal of Banking Behavior & Research. 11 No. 1, July.
  3. Geoffrey M. (2004) “Modern Trade: Difficulties Encountered,” International Business Journal, 3, no. 2, August.
  4. Howard P. (1999) “Innovations in Banking: Effective Service Delivery” Journal on Financial matters. 5, no. 3, September.
  5. John B. (2001) Problems, Solutions and Prosperity: a Post-Modernism Approach, University of Birmingham, Edgbaston, Birmingham B15 2TT, England, UK

 

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