Economic Implications Of The Recent Credit Crunch Finance Essay
The purpose of this research is to show how the economic impact on banking sectors based on the credit crunch of the banking systems in the case study that was carried on in the United Kingdom. To start with is a briefly definition of what a credit crunch is and how it has influenced by the economic condition of a given nation. A credit crunch also known as credit crisis or in other words a credit squeeze refer to the reduction in the general acquisition or availability of loans or credit from a bank .It can also be analyzed as a situation in which conditions that a re required for an individual or a firm to obtain a loan from banks have been tightened .A credit crunch has been seen as the outcome or a result of rise in the official interest rates charged by the banking sectors to those who acquire loan from them. The relationship between a credit crunch and interest rates keep on changing over time such that of the two either the credit might become less available at a certain given official interest rates or the relationship could not be clearly stated.G.Phliph (2008)
According to Western, David(2004).A credit crunch is said be caused by the reduction in the market prices of assets that were being offered in the market. Prices are said to collapse hence resulting to a very severe situation referred to as the financial crisis in the market. Credit crunch tend to greatly affect investors who might have come late to the market and are said to be prone to bankruptcy if they are not stable enough. In a situation where by there happen to be a credit crunch it is advisable for the investors to sell or shift to a liquidation if the affected business has got insufficient or little capital to survive the post –boom stage of the credit cycle. Many practices of loose credit have been argued as the cause of the prolonged credit crunch in the market and this has been witness ed in the United Kingdom some years back. The presence of the liquidity crisis hinders growth of a given country and therefore it is argued that for the nation to attain growth it must be able to overcome the problem of the liquidity crisis. Masciandaro, Donato(2004)
In several occasions credit crunch is said to be accompanied by a flight to quality by both the lenders and the investors as they prefer less risky types of investments. In the modern economies banks are said to play a crucial role in the determination of living standards in any given nation all over the world. Banks stimulates and collects saving from the society and allocate them among different firms and sectors that need capital to run their economic activities.Thruogh this allocation of the resources banking sectors can determine and even alter or change the path based on economic progress mainly in those countries that are said not to have developed other sources of finance. The other role of the banks is associated with allocation of credit. From the economic point of view, banks are said to be the cornerstone or the pillar of economic prosperity this is due to the fact that banks offer deposit protection and payment system services.
According to Schipke, Alfred (2004) Banks from economic point of view are those institutions whose main purpose or role involves receiving of deposit that is saving fro the society and granting or issuing of loans to firms and individuals. These deposits which banks receive from the public are used to finance most of the loans. This process is known as financial intermediation and is mostly applied by commercial banks. In the process of granting loans banks face some risks in their operations such risks involves credit risk which is also refer to as repayment risk ,liquidity risk which is concerned with differences in maturity between liabilities and assets ,interest risk and other risks associated with fluctuations of relevant prices in the market(such as the exchange rates).
The UK case study is all about analyzing of the issues that are concerned with cost size and the stability of bank credit and relate them with to the underlying risks that are said to characterize banking. This study deeply analyses what determines cost and the amount of credit which is available to the societies in general. Banks stimulates economic development therefore they must be considered as the key player of the countries economy in all aspects of development. By so doing there exist a relationship between bank credit and the gross domestic product of a given country in the world.
For any country to develop there must be a defined link between the financial and the economic development of that country. Both the financial system and the economic development tend to influence each other. Financial development may bring about economic development by improving the allocation of the public savings in the country’s economy while economic development may enhance growth in the financial systems by creation of the required infrastructures and also good or better institutions. In early 1990s many developing countries were viewed as victims of credit crunch particularly the United Kingdom of America.Imposision of higher interest rates was said to have reduced cash flows and with this effect pushed down prices of assets hence making the balance sheets of many firms weak. As a matter of fact loan losses and lower asset prices for instant those in the real estates have been considered as important into the equity of most of the banking sector in the economy. This made the banks to increase their interest rates and also to cut down lending. Seltzer Brad and Roubini Nouriel(2004)
Credit crunch is more severe or pronounced in small firms than in large firms since the large firms are said to either renegotiate their loans or they could directly go to bond markets. In a country like the UK the government is said to rescue their firms from credit crunch situation. According to Gilchrist et al.(1994) ,there are many evidence that indicate a flight to quality in lending of money as a reduction in credit share which is flowing to the borrowers with high costs. it has been argued that the firm’s net worth is a good determinant of the capacity of the debts the firm can hold in a given period of time. Firms that happened to have a huge debt in relation to equity will face or encounter insufficient share in the financial outcome. For example if some investment projects are of a fixed size only the firms with highest or stable net worth will have the chance to finance the investment directly but those firms with insufficient or low net worth will not be abele to finance .In a credit crunch situation, banks should consider the good risks and abandon the bad risks. Tran Van,(2002)
From the research carried on by the bank of England it is clear that or it has been observed that the recent development in the financial markets affected the supply of credit to both the households and corporations hence cause banks to pull back in lending .This show that the availability of credit to the households seem to have reduced because banks were not in position to lend the or issue them with loans.The reason behind this was that banks because of much losses and the economic shocks which were witnessed .During the period when the economy is said to be booming means that there exist a lot of cash in circulation and most of people are stable financially stable hence they need not to get loans from banks. Another study show that credit crunch which is associated with tightening conditions that hinder the availability of the securing credit or loans have discouraged many people from borrowing to finance spending on both commercial property and residential.
The research was based on the effect of credit crunch on housing market which evedually shown that the prosperity of this kind of the market depended largely on the financial market whose responsibility was to equip the consumers with finance or credit which they could use to rent houses. The effect of the financial market turbulence since the year 2007 has resulted to a decline in the forecasts of the economic growth in most of the developed countries in the taking in consideration the United Kingdom of America. The government of the United Kingdom in the year 2008 was said to have cut down its forecasts for the GDP from 2.5% to 3% during the 2007 budget to 2 to 2.5% in the pre-budget of the year 2007.
The downgrade in forecasts of the UK GDP was attributed by the increase in the interest rates in 2007 first half and also the disturbances which were associated with the financial market. From this point of view it has been noted that credit crunch affect macroeconomic more than it was expected. Governor of bank of England had argued that uncertainty based on the scale and location of losses has raised alarm on the adequacy of the bank capital therefore highlighting that the economic expansion geared by the ability of the banking system to finance. The argument made by the researchers of the United Kingdom state of economy and the effects of the financial market shown that financial market play a major role in economic growth which simply mean that financial markets are backbone of country’s economy.
The present healthy of UK economy depends on the ability of the banking sector to implement its pricing and also to restore confidence in balance sheets. In the recent past most of the United Kingdom banks have made some steps in the establishment of losses and repair of balance sheets. It has been argued that if banking sec to fails to put its premises in order the problem may have an impact to macroeconomic. According to Tornell, A. (2003) trade liberalization is also considered as another source of credit crunch in the United Kingdom because it is said to enhance growth.
Those nations which have such sort of agreements tend to fall victims of credit crunch because it has effects on the financial liberalization in most part since it is noted to have been associated with major features of credit crunch which involves risks capital flows, lending booms and also crises. United Kingdom argued to have liberalized both its finance and trade and involved itself into the North America Free trade treaty but its growth progress was noted to have been unremarkable as you compare with its neighboring nations.This financial liberalization was seen as a major source of crises. Yoo, Jang and Hooley, Richard(2002)
The case study of the UK economy indicate that many of the countries that are faced with severe credit market imperfections and also financial liberalization have experienced rapid economic growth but in the same time are prone to crises. From the view of Tornell liberalization is seen to catalyst the process of economic growth because it makes financial constrains less difficult of which this can be witnessed if and only if the agents absorb credit risks which brings about crises in the economy. Rapid growth in UK has been associated with some components such as the financial fragility and the increase in the financial liberalization. Since the year 1990s United Kingdom’s credit crunch in the wake of its crisis has been noted to be severe and also lasting for long period of time. Sinn Hans-Werner(2001)
The links between liberalization and growth are the key causes of crisis in any country in the world both the developed and developing economy. There two types of sector that has been used to analyze or draw a clear line of fiction on how firms brings or contribute to credit crises. One of these sectors being the tradable sector which is said to overcome the problem of credit crisis due to the fact that most of the tradable sector firms have accesses to international capital sectors or markets of this not applied to the non-tradable sector firms. The non-tradable sector firms are said to depend only on the finance they get from the domestic banks.
In so doing it has been argued that trade liberalization the productivity of the tradable sectors hence increasing growth in GDP while the financial liberalization speeds up investments in the firms that have or experience financial constrains such as the non-tradable firms. For the United Kingdom to escape or shoulder the burden of the credit crunch it must urge its firms to undertake credit risk but this can only be possible through the easing of the constrains associated with finance. Financial liberalization is viewed to give rise to restrictions that are associated with risk taking and also the implicit and explicit sort of bailout that are said to provide cover to the creditors against crises.
According to Tornell (2003) in absence of crisis, growth in risky economy has been considered to be faster as compared to the growth in the safe kind of economy. If the level of crises is high, then the firms will not take on credit risk because it will be of no profit at all. In the presence of crisis, credit growth is observed to decline drastically. For the United Kingdom to solve this problem of credit crunch it should therefore encourage its firms to form links with foreign countries in order to be able to receive a share of foreign direct investment hence shifting their access from the domestic banks credit to international financial markets. The recent credit crunch of United Kingdom can not be explained as resulting from a fall of loanable funds but to the fact that UK has attempted to sell some of its banking system to the foreigners hence this causing an increase in crisis which hinder the domestic banks from being able to fund firms in economy.
From economic point of view it was argued that financial fragility can not be dealt with through limiting banks flows and advocating for foreign direct investment because limiting of banks flow could be said to barer growth in the countries economy. Foreign direct investment can not be seen or considered as alternative for risky banks flows. The best way for the United Kingdom to respond to the problem of credit crunch is by making some implementation to the judicial reforms which is ought to improve domestic credit markets. If this is not put in action the liberalization is said to bring about financial fragility in the UK economy because this would mean that large groups of firms will be financed by the risk bank flows. Tornell (2003).
All the domestic firms need to be financed adequately in the situation of the crises. Apart from the United Kingdom, other nations such as the Mexico have been reported as victims of credit crunch because they rely mostly on the income from the exports giving less concern to the domestic oriented firms’ .Non-tradable sectors should not be put a side since low investment in them may later present barrier in economic growth of any given country in the world. As earlier argued that the correlation between the liberalization and growth as the major cause of financial fragility has enacted a controversy from a number of researchers who tend to claim that there is not a significant relationship between the two. Gisdakis Philiph, Felsenheimer Jochen(2008)
The controversy has been said to result either from sample being considered by the country or to the use of openness indicators. For a country to be in a capacity to analyze the impact of the liberalization, it must forget about the sample used and eye on the financial markets that are func6ional in the economy. It should also come up with a model; that can be used to make or draw a clear line of comparisons based on the behaviors of many macroeconomic variables in country’s-year that is both open and closed. It is important for a country like the United Kingdom to analyze the existing links between growth, liberalization and the financial fragility.
The effects of liberalization in economic growth can be achieved through the process of analyzing many macroeconomic variables before and also after the onset of the liberalization. The United Kingdom banking system recently has been argued to be in wanting state of operation which has introduced the country to a situation leading to a credit crunch. There are mere constrains to why the banking system have stopped lending out money to the firms to expand economically. Some the major reasons are that the central bank of the United Kingdom or the bank that prints money and supply to the circulation system have come up or imposes new regulatory that hinder the lending process. The direct credit control has been imposed by the United Kingdom central government on the banking system.
According toGisdakis Philiph, Felsenheimer Jochen (2008), the existence of bad debts has been reported from a period of both the careless and also the inappropriate lending which were associated with losses for financial institutions and those investors in debt. Here is a bit of literature review on one of the leading lending company in the United Kingdom .The name of the company is paragon which is known for the provision of prim-to-let mortgages to both the professional and the investors’ landlords. The company was first launched in the year 1995 and is said to have attracted many customers over the last 13 years it entered the market. Vartia, Pentti and Kiander, Jaakko (2009)
It seem to have accommodated thousands of customers up to-date which indicate that it currently has a capacity of 40,000 landlord customers and also it is servicing 90,000 individual accounts with worth billions of assets being managed. This company is said to be the leading member among the council of mortgage leaders’ .It play the centre role in its buy-to-let working group and also among other intermediary mortgage leaders Associations such as the Association made up or composed of residential letting Agents and that of the National landlord Association. The key point of submission of this company are also provided in order to enable the reader to understand fully how this company operates and reacts to the economic shocks.
The private landlords are said to take the advantage over the marked slowdown of the sales of houses and the limitations that have been put in place to the availability and also the growth of social housing stock.
These private landlords are said to provide other sources of accommodation to many people while the modern PRS has come with other housing choices or alternatives that are said to accommodate only those people who are said to be unable to buy a house or home. The role of PRS has been brought to a greater focus by the prevailing economic situation in the country. In centrally the private landlords are eager searching or looking for those people who can not find or acquire a home in the social sector. Vartia, Pentti and Kiander, Jaakko (2009)
They are said to work extra harder to meet the needs of their customers. There is a policy which has been set to regulate and control the renting process that is operated by both the government and the private landlords. It is upon this policy to encourage the private landlords to improve their commitments on the private renting sectors. If there any reforms to be made on the regulatory framework should take into account a better interests balance between both the landlords and the tenants.The prosperity of this business is the product of the two parties therefore there should be no discrimination whatsoever.
The risk that might be there is only if the landlord has been discouraged from operating in the sector. Government has the mandate to support banking sectors and to strengthen the market for mortgage finance but was blind to ensure a healthy buy-to-let market. Over the last years buy-to-let have been said to have overwhelm the growth of the PRS by its unique management standards. From the review of United Kingdom Company of buy-to-let it was observed that still there is Avery strong demand when it come to the matter or issue of the private renting of properties in the market. Despite of the problem of the lack of liquidity in capital markets, the buy-to-let is said to be doing quite well in its operations.
The government plays a major in restocking the banks so that they can be able to provide lending services to the investors but this action tend to have effects to the Prime BTL (buy-to-let) assets. Policymakers have been urged to differentiate between the prime BTL lending and what is referred to speculative property investment. The two kinds of activities are said to have great variation and should not be confused to one another. The Prime buy-to-let target professional landlords who are said to have a long-term investment in property. Speculated property is the opposite of the BTL since it targets those people who are after short-term gain and it is supported by the property investment clubs. At present the BTL must be protected and encouraged even though it is said to criticize the healthy PRS.In the current economic situations there many roles that have been increasing now and then.
To begin with the PRS has come up with a critical role in the housing market of the modern society although there is the tendency of the housing policy to embark on much focus on the ownership of home and housing that is affordable. Over the last twenty years of operation the sector claimed to have underwent through a period of desirable changes together with modernization .During this period or process it was noted that the PRS has covered the gap that existed between the social renting and self-occupation which is also regard as the owner-occupation. By so doing the PRS has been considered to have c contributed largely to housing and what so called the regeneration in the United Kingdom.
Within the population, the modern housing sector that is the PRS was considered as the most preferred by many people in the United Kingdom. The demand for housing in the United Kingdom grew to higher levels based on the demographic pattern which encompasses the student scholarships to UK, other kinds of migration to UK and also the demand resulting from the young professionals. This has brought about or other resulted to higher demand on private sector of housing renting. Buy-to-let (BTL) has indeed increased accommodation opportunities and encouraged much of the private renting which offer competition to the landlords of the PRS.
Through this competition, more choices have come into existence and the improvement in the standards of the accommodation in the sector has been witnessed. The general fundamentals of the BTL sector are still strong even after the paragon to fall a victim of funding constrains from those lenders who in the past venture into these markets and raise funds. The BTL differ from the other sub-Prime lending and must therefore not be confused with them but there is a need f or separate treatment when government is trying to respond to obstacles in both the banking and sectors concerned with housing.
There are some agreements that were made by the treasury and the banks that had received support from the treasury recapitalization scheme whose purpose is to urge these banks to take the role of keeping in touch with the maintain of their lending to the owners of homes and also other micro-businesses. It was later discovered that the nature of the agreed commitments was not clear. Some suggestions that advocate for the banks that have been assisted to exclude lending against risk assets. There should be no return to lending practices that are not responsibly done.
As per concern the recent years market operations the lending of BTL must not be put in the same group with sub-prime mortgages. It is argued that for any professional landlords to use the product of BTL in order to understand the genuine BTL lending and the important role of investment in the PRS should have the chance or other the mandate of inform9ng the government action geared toward the reviving of the lending levels. Many people tend to confuse the two types of investment of they are said to have Avery big differences. Speculative property investment in case applies to those people who normally pay a lamb sum amount of money in order to invest at a discount prices.
The target here is making profits based on the short-term. In the case with the BTL investments target the professional landlords who are interested in long-term sort of investment. From the research which was carried on by the association of residential letting agents have shown that most of the landlords prefer to retain their portfolios for at least 16 years. The presence or the availability of the Prime BTL is important for the PRS progress and if need be it must be considered as a part and parcel of the government response when there occur constrains in funding. The competition offered by the BTL against the PRS play a major role in encouraging the full participation of the PRS in meeting the needs of the landlords which is the provision of housing sector. Ramaswamy Srichander (2004)
In the section of arrears and repossessions it has been said that the most of the borrowers performance remains wanting despite the prevailing conditions in the mortgage market at large. At the professional terminal of the market demand has been noted to be still strong which was also considered as the cause of increase in the tenant’s demand in the present environment. The United Kingdom government for this matter has been concerned with the implementation of any approach that could bring a bout repossession as many borrowers are victims of financial constrains as a result of credit crunch.
Paragon use a leading approach to the situations whereby one of their members is faced with the difficult of repayment of theirs debt. Where arrears are noted paragon consider a basket of options maintaining its priority which is geared toward ensuring the sitting of tenants. According to the priority of the paragon it is clear that even if the tenant has got no money due to the prevailing situation of the credit crunch, the paragon will not chase the tenants a way but instead will allow tenants to continue sitting in the property and also go a head and ensure that the property is professionally maintained. This action makes it possible for the property to remain safe and to maintain the rent payment profile of both the paragon and tenants.
Critical evaluation of recent credit crunch in banking system.
Since over the years the financial institutions have been said to have suffered severely from the problems associated with credit risks, the major causes of banking problem lie on the foots of lax credit standards for borrowers and counterparties, uncredable means of managing portfolio rist.A borrower may fail to settle debts because of changes in economy which might have not been expected by the borrower. In real sense credit risk can been stated as the potential that a bank borrower or bank counterparty will not be in a position to repay its debt as agreed. Banks are said to carry out a role based on the management of credit risk whose main aim is to maximize bank’s risk adjusted of outcome. Banks should therefore take control of the entire portfolio and those in individual’s transactions. Seltzer Brad and Roubini Nouriel (204)
With the knowledge on credit risk, banks need to consider relationship that holds between other types of risks and the credit risk. The largest source of credit risk in all banks are claimed to be loans other sources relate to the activities of the bank. The work of supervisors in any of the banking system is manage credit risk through drawing awareness from the experiences that might have occurred in past. The credit risk management program in banking system is responsible for maintaining of the risks. The healthy of country’s economy depend on the financial system of that country this is because it plays crucial role in channeling money from savings to those firms that are in the process of investing. Vartia, Pentti and Kiander, Jaakko (2009)
Failure of the financial system to fund these firms the economic growth will not be experienced which means that for an economy to operate to its full capacity or efficiently financial institution s such as the banking system must per form its role. Banks as lenders are said to have little knowledge on the return of the investment project of the borrower and also the risk associated with it. Interestingly the borrower with highest risk are said to have higher demand of loans and also are those prone to pay high interest rates because they know that they might fail to pay back. Financial institutions such as the backs are known for being good credit risk in the market but they should learn how to differentiate bad credit risk from good credit risk. When the project in which the borrowers have invested the fund or loan got from bank fails it is the lender who suffers largely. Ghosh.B.(2001)
There must be restrictive covenants between the lender and the borrower that states the terms and condition of payment of the loan. Through the process or loaning or lending funds to the borrowers’ banks tend to scrutinize the borrower’s account in order to be able to determine whether the borrower is able to service the loan after being given. The borrowers account in most times tends to provide the lender with appropriate information about the borrower hence being able to monitor his or her behavior. During the time of economic shocks a certain percentage of banks suffer from losses associated with loans hence becoming insolvent. In the United state there is a corporation between the government and the banking system whose main role is to safe guard the welfare of the depositors. Indart, Gustavo and Berry(2003)
The federal deposit insurance corporation assures the depositor that in case the bank collapses they must be compensated of their money by the government which means that depositors should not rush to withdraw their deposit if bank is about to collapse. This government insurance is not the only way in which the government can safe guard the welfare of the depositors but it also aim in providing support to the domestic banks when in case they come across the situation in which its depositors might ran away from being the clients of that bank. Banks that have corporate with the government are said to have advantage because the government will provide them with incentives in which they can take on great risks. Most of the failures associated with banks originate from those people who actually would want to take the advantage of the government insurance.
There must be a certain criteria in which the banks should operate on in order to understand the borrowers, the purpose of the credit, the structure of which is associated with the credit and finally the source of the borrower’s repayment. This criterion is referred to as credit granting criteria. There must be a credit limit system established by each bank at all levels of borrowing. In the process of credit risk management banks are advised to come up with a system of rating the internal risks. This system must be consistent with all the activities that take place in the bank. Weaknesses resulting from credit risk management might be considered as the major source of most of credit problems in financial institution. Bhattacharya Sudipto (2004)
From the case study which was carried out in the United Kingdom about the economic implications of the recent credit crunch shows that a credit crunch is just but a situation where the financial institutions such as the banks tightened their condition of lending or issuing loans or funds to the public or firms in economy. A credit crunch has been seen as the outcome or a result of rise in the official interest rates charged by the banking sectors to those who acquire loan from them The presence of the liquidity crisis hinders growth of a given country and therefore it is argued that for the nation to attain growth it must be able to overcome the problem of the liquidity crisis. Indart, Gustavo and Berry (2003)
All the financial institutions in the country have been viewed as the corner or pillars of the economic growth of that country. They play a major role of channeling funds to both the firms and individuals who want to invest in the economy. Of all the financial institutions banks are said to the most victims of credit risk because people rely on them to acquire loan as source of capital. The UK case study based on two mortgage investors brings out a clear illustration of how the credit crunch affects the country’s rate of growth. For the banks to do away with the problem of credit risk is by coming up with a system of management whose mandate is to control and mange such risk from occurring again in the banking sector or system. There is no financial system in economy which is said to be resistant to economic shock. Economic growth and credit crunch go hand in hand.
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