The Global Banking Crisis - What is the Credit Crunch?

Birth of Banking  | Banking Mentality | Sub Prime | Housing Bubbles | Liquidity Shortage | Blame Game | Impact | The Future

Introduction - the credit crunch is now a globally recognised term to describe an increase in the cost of borrowing, coupled with a reduction in availability of financial credit to businesses and individuals. It is happening at a time when global inflation is rising due to the rising cost of oil, raw materials and food. The credit crunch is having a profound effect not just on Governments spending, Banking Institutions and consumers, but also on entrepreneurs and small business owners. Organisations, previously reliant on easily available overdrafts, bank loans and unsecured credit, are now struggling to raise working capital, manage cash flow and hold down operating expenses. As housing bubbles burst in the UK, USA and many other richer nations, financial institutions have restricted lending, stock markets have fallen and consumers are tightening their belts. The impact of the credit crunch means major economies may be slipping into a technical recession (generally measured as a contraction of the gross domestic product over a number of quarters). So what are the causes of the credit crunch, who is to blame and what are the specific impacts on business?....

The Birth of Banking - in Italy in the fifteenth century, the Medici family made money lending respectable and later formed the birth of banking. They literally sat behind benches or "banks". They were currency exchange dealers who made enormous commission from individual trades. As the church considered charging interest a sin, the Medici innovatively made their money on the commission they charged per trade as foreign exchange dealers. The depositors to the Medici bank earned ‘commission’ based on the length of time money was left on deposit. These became the first ‘creditors’. Over time, the Medici trading extended to Florence, Venice and then Rome. Giovanni Medici died in 1429 he died, leaving a legacy that formed the birth of the banking process that we know today. The strict relaxation of the past relaxed as societies attitude towards risk and reward radically changed..

Modern Banking Mentality - traditionally, high street banks and building societies encouraged savers to deposit money with them, typically in the form of instant access savings accounts. In turn, these institutions would lend this money out to borrowers as an increased interest rate. This lending takes the form of mortgages, unsecured bank loans, business finance, bridging loans or unsecured loans.   The reputation and creditworthiness of these old banking institutions remained second to none.  In addition, there were few cross border lenders and electronic trading of large debt related funds at this time.

As the economic stability of the 1980's and 1990's continued, global competition to lend money intensified, as investors rushed to profit from economic growth in sectors like residential housing and commercial buildings. As a result, a range of complicated financial products (asset based lending and capital market collateralization) and processes were created to satisfy the increased demands for borrowing by institutions. The lure of corporate profits and loosely regulated financial markets, allowed institutions to create new financial mechanisms.  This allowed institutions to lend hundreds of millions of pounds to each other, quickly, and at a push of a button. The  process of globalisation continued as the developed world and consumed more and more import is cheaper products from developing economies, allowing inflation and interest rates to remain stable and relatively low. The credit boom had begun providing a sea of cheap credit to businesses and individuals seeking to invest and obtain quick profits.  Stock markets around the world rose in value, as private equity capital firms borrowed heavily in order to invest, which in turn pushed shares higher in higher. 

The financial world also created a whole range of new complicated financial instruments to allow riskier investments to be made over a shorter period. The options and futures markets developed to allow even more credit to be used to invest in the future value of companies, without actually only the shares.  In addition, hedge fund investments and short selling processes, created an environment in which profits could be gained from a companies future failure as well as success.  Using other people's money, traders invested more volumes of cash, in a fast moving electronic environment, using complicated instruments, that were becoming less centrally regulated by governments. Institutions spent millions lobbying governments to provide a 'lighter touch' regulatory environment.

Gradually, mortgage lenders and banks did not need to grow organically (via increases in their cash reserves from small savers). They could simply borrow huge sums of money from the international secondary money markets in order to finance loans and mortgages to its own domestic customer base. Failure to join in and compete had the effect of threatening smaller, more traditional lenders (such as mortgage brokers or building societies), who also took more risk and exposure to potential bad debt on the secondary markets. Consequently, in 2007, two thirds of UK mortgages issued were funded in this way. The volumes and cost of this money between institutions is determined by the future market valuation of collateral of the debt. So in boom times, equity in homeowner's property and in the commercial property market continued to rise. During this period, credit rating agencies gave some institutions reselling mortgage debt a AAA credit rating. This gave an added measure of market confidence in the value of the collateral. Shareholders were happy, credit was cheap, and property prices soared in many economies. Eventually this house of cards began to collapse....

Sub Prime Mortgage Crisis - sub prime lending or 'second chance' lending refers to mortgage loans offered to homeowners with low incomes and adverse credit histories, that fails to meet the 'market makers' lending criteria. Local mortgage brokers and intermediaries were incentivised to sell these high credit risk products to groups of people with a regular income, few savings for a deposit and poor credit histories.  By mid-2007, sub prime mortgages accounted for 10% of the total US mortgage market, representing $1.3 trillion worth of mortgage loans.  In the USA, the two main market makers are the 'The Federal National Mortgage Association' (Fannie Mae) [1] and 'Federal Home Loan Mortgage Corporation' (Freddie Mac) [2].  Together they guarantee or refinance, three quarters of the £12 trillion mortgage market.   The growth and scale of foreclosures in the sub prime market has been a a major contributor to the global credit crunch.

The Housing Bubbles Burst - the long periods of economic growth in the American housing market finally came to an end in 2006. Institutions suddenly realised that the increasing number of homeowner foreclosures were massively devaluing the value of previously overinflated assets. The interest rates that sub prime borrowers were originally offered, suddenly shot up to over 5% making mortgage repayments expensive and in many cases completely unaffordable.  As a result, there was a tidal wave of defaults from the low income, poor credit history sub prime market.   In 1997 over 1.3 million foreclosures occurred which was an 80% increase from 2006. By February of 2008 nearly 9 million mortgage holders, representing almost 20% of the total in the United States, were in negative equity. Aggressive selling to people who could not reasonably expect to repay the debt has shown, the level of debt had simply become too great.  in addition, the housing bubble is of most western economies were beginning to peak as people realised that unsustainable prices would inevitably come to an end at some point.  US Bank's ability to provide huge volumes of cheap credit to the mortgage market, credit markets, businesses and individuals, had been artificially enhanced and undisguised through the process securitisation.....

Securitisation - unfortunately, most credit risk (sub prime mortgage debt) has historically been, 'packaged up' up in other debt and then sold onto the money markets (in the form of Residential Mortgage Backed Securities [3] (RMBS) bonds and also Collateralized Debt Obligations [4] (CDO)).  This process is referred to as securitization and had the effect of disguising the risks of sub prime bad debt. In simple terms, securitisation allows banks to exchange ordinary loans into trade securities (bonds). These bonds were purchased by other institutional investors from pension funds from all over the world.  Most UK mortgage debt has had exposure to US sub prime debt as institutions began to realise they had no idea  how exposed they were to bad debt on their balance sheet.  To the homeowner is financing was irrelevant and behind the scenes, yet to the banks it meant that they could pass the risk on to bondholders ,who in turn passed the risk to another institution.  Bond holders credit ratings were officially calculated and published by credit rating agencies such as standard and Poor's and Moody's and Fitch.  the market looked to these credit rating agencies for guidance as to the credit worthiness of the holders.  The highest credit rating is AAA, where as a BBB  is a high-risk non investment grade. Unfortunately, the process of securitisation meant that these agencies did not accurately assess the risk attached to securitised bonds.  Many still had AAA ratings which meant they were similar to US government bonds.  The cataclysmic misjudgement by these credit rating agencies is now leading to the potential threat of class action litigation by investors, who incorrectly believed that money was ironically "as safe as houses".  The collapse of Northern Rock in early 1997, among other corporate casualties, highlighted the scale of bad debt exposure had become in the banking system. The inappropriate lending 'easy money' culture of the past has finally caused a situation where banks simply don't trust each other to know how much bad debt is wrapped up in inter banking loan agreements.   The long term boom in UK for house prices unfortunately reached in peak in 2007, just when major financial services organisations began to report profit warnings from writing off sub-prime linked bad debts.  By July 2008 it was estimated by the International Monetary Fund (IMF), that the credit crunch has cost financial services organisations an incredible $472 billion.

  Lack of Money Supply - at the sheer scale of the sub prime losses became apparent, banks around the world were naturally reluctant to lend to each other when they realised that even the banks themselves are becoming a potential source of major bad debt.  Consequently, there has been a dramatic fall in money supply. In particular, there has been a collapse in the volume of mortgage lending, an increase in repossessions and  a lack of business investment as market confidence evaporates. To make matters worse, banks have increased the bank to bank interest rates they charge each other to reflect this increased risk of bad debts. Banks have simply become risk averse in an economic climate of fear, uncertainty and doubt.  Central banks were forced to provide emergency funding as well as cut interest rates to relieve the pressure on borrowers. Many banks around the world had to 'shore up' these cash reserves on their balance sheets, as opposed to redistributing this cash through the supply chain of the financial system.   As a result, first time buyers have found it almost impossible to get on the housing ladder because of the mortgage shortage. Today, UK property prices have fallen 10% in one year and mortgage lending approvals are down 80%. Most economists expect prices to fall further and for the UK and US to slip into recession. The US Federal Government has reacted by recently intervened by pumping $152 billion of liquidity into the mortgage market in its 'economic stimulus package' [5].  Similar attempts by the UK Government to encourage banks and mortgage lenders to relax their lending position have had little effect on the situation.  Under the £50 billion pound scheme, UK banks will be able to swap potentially existing risky mortgage debts for secure government bonds. 

Who is to Blame? - it is easy to point the finger and blame it all on American mortgage lenders.  Yet, the global credit crunch is highly complicated and involves many stakeholders including;' Government central banks, regulatory watchdogs, credit rating organisations, financial institutions, investors, brokers and consumers.  Each had its agenda and priorities...  Today, housing bubbles in most Western economies are bursting as an indulgent decade of wealth creation from property speculation comes to end.  Of course, in the past decade voters felt richer, (so Governments did not generally not interfere through legislation or via central banks).  Likewise, record corporate profits kept shareholders happy.  In the good times, few Governments, small businesses or individuals put savings aside to prepare for 'a rainy day'.  In fact, most Governments public borrowings exposure increased, average consumer savings levels fell, and mortgage and unsecured consumer debt rose dramatically.   The moral hazard became a commonly used phrase in the media.  This describes the risk that bailing out financial institutions that have behaved recklessly, will simply encourage more reckless behaviour in the future. In all probability there will be an increase in market regulation following a return of stability and a time to pause and consider who was actually to blame.  In hindsight, Government policies should have mandated to regulatory watchdogs to identify lending practices and threshold affordability limits.  Yet in the boom times, most Governments left the market equilibrium to balance itself, using a 'light touch regulation' approach.   So is market regulation there to protect consumers against themselves? to dictate how big a house or car they can afford? or is it the job of regulators to let the market correct its own mistakes and simply ensure integrity, fairness and honesty in market process? Managing any fast moving, highly complicated, automated and electronic market, remains an immense challenge for any regulator.  Already short sellers have been blamed for accelerating the collapse of major banks.  Conversely, the short sellers have blamed a lack of Government regulation that allowed banks to get into such severe difficulty, that it would probably gone bankrupt anyway. It is likely that the blame game will continue an may turn into litigation as organisations point to their nearest connecting link in a complex global monetary system.

 Lessons from Past Bubbles - hindsight is a wonderful thing and there are many booms and busts in financial history that can provide valuable lessons regarding the causes before the crash and the solutions for recovery. In the 1920s, the great crash and subsequent depression that occurred, was caused by the huge explosion in demand for manufactured goods such as cars, fridges and radios. This desire created a huge demand for consumer credit to all ordinary people to purchase these items.  On the 28th of October 1929, now known as Black Monday, investor confidence collapsed as the Dow Jones index lost 90% of its value and the US GDP shrank by one quarter in the Great Depression that followed.   More recently, the dotcom bubble refers to the explosion and subsequent collapse of of Internet technology stocks and share values.  This provides a very recent example of short term greed and miscalculation. In this example, credit was extended to both corporate investors as well as newly empowered individuals, seeking quick returns by using other people's money. There are numerous other booms and busts throughout financial history - the common theme has been the fact an over indulgence of credit has fuelled sudden, overexcited investment decisions.  People collectively believe that markets will continue to rise as everyone feels comfortable and secure in their new-found paper based wealth. 

Impact on UK plc - the impact on businesses large and small has been severe....  In particular, smaller limited liability companies the beginning to feel the effects and some are struggling to growth or expand. The lifeblood of most small businesses is cash flow (liquidity).  The positive flow of cash through any small business is essential; business suppliers and employees expect payment on time while customers are increasingly interested in interest free offers and favourable credit terms themselves. An increasing number of small businesses are facing corporate insolvency (in other words the business is unable to maintain long term fixed operating expenses to fund growth), leading to company winding up petitions [6], personal bankruptcy or corporate insolvency.  With the ability to raise additional capital reduced and economy stagnating, cash flow is the number one concern of managers.  The Bank of England reported at the beginning of August 2008, that the M4 money figures ('spare cash available') of companies across the UK has fallen to its lowest level since the 1990's.  This measure is a reflection of the spare credit facilities available to companies (which has fallen by 13% between Jun 2007 and June 2008). 

Cash strapped smaller firms are cutting back on business investment while attempting to delay payments to other supplier.  Trade credit terms for business to business transactions are becoming more together as each company in the supply chain attempts to manage its cash low more effectively.  Despite recent UK legislation [7], late payment is a particularly difficult problem to regulate in sectors like retail, where margins are thin and larger suppliers can dictate trade terms to smaller ones.  Typically, smaller suppliers are dependent upon large orders form the supermarkets or high street networks.  One of the solutions to this problem that is becoming increasingly popular is to refinance debt through debt factoring. This is process of selling debt onwards in order to provide short-term finance (positive cash flow) on a continuing basis.  In addition, the credit crunch is also pushing up core operating expenses.  Consequently, small business is attempting to combat the impact of inflationary linked fuel and raw material bills, by changing their basic behaviour; The Carbon Trust [8] recently found that 70% of business leaders are attempting to improve energy efficiency to reduce wastage.

The daily global publicity surrounding the credit crunch has destroyed consumer confidence and made individuals feel nervous and worried about their own financial future.  Consumers have tightened their belts knowing that a recession is around the corner.  They are extremely concerned about whether or not any money they have saved in their bank is actually safe.  So as consumers cut back on luxury items such as holidays and cars, businesses who rely on selling these types of products and services have got into severe financial difficulty.  Many small businesses have gone into administration due to the lack of consumer demand.  For instance, hundreds of estate agents have had to close branches, airlines have gone into administration, sales in high street shops have collapsed and holiday companies are reporting drops in future bookings.  Failure of any big business such as the airline has a server knock-on effect on its own suppliers, who may rely on large orders from them for their own survival.

  The Future? - the difficulty with a liquidity crisis and a global recession is the level of uncertainty and volatility in all types of markets.  Nobody is sure whether other banks will fail and the impact this will have on the overall global financial system.  A crisis has its own momentum, and like an infectious disease, spreads between institutions and across geographic boundaries.  The real economy is clearly being impacted by the shortage of liquidity, and will inevitably lead to job losses, falls in house prices, reduction in business investment, business failures and recession.  The most important ingredients is confidence in the financial system.  Modern economies cannot operate without credit and credit cannot be provided without lenders being confident they will receive their  money back.  The London interbank offered rate or (LIBOR) is the interest rate banks charge to each other to borrow from each other. The drastic reduction in interest rates by central banks has done little to influence this rate which is a direct measure of the confidence of banking chiefs.  Until the true scale of hidden losses is revealed, it is unlikely that confidence will return. 

The interventionist rescue plans by most Western governments to provide loan guarantees, preference shares and equity in fledgling financial organisations is a vital first step on the road to recovery.  Politicians are also providing reassuring public messages that the government will do whatever all they have to to maintain stability.  In addition, central banks can assist further in the future by cutting interest rates and pumping more money into the economy to facilitate liquidity. Governments and central banks do have the ability to buy up toxic bad debt such as securitised mortgages, to provide confidence for investors.  Governments cannot afford to allow major financial institutions to fail as banks tentacles spread throughout all aspects of a country's economic prosperity - from building roads and schools and hospitals to funding small businesses and lending homeowners mortgages.  The government's fiscal policy of changing taxing and changing spending may also impact on future events, depending upon the level of government intervention in taking stakes in major institutions, as well as the needs of the UK's voting population.   It is likely that small businesses will have to do whether a long and painful economic storm through conserving cash and acting prudently and conservatively.

External Links and References

1  Federal National Mortgage Association

2. Federal Home Loan Mortgage Corporation

3. Residential Mortgage Backed Securities

4. Collateralized Debt Obligations

5. The White House Economic Stimulus Package Bill 2008

6. Company Winding Up Petitions report from Justice.gov

7. Late Payment of Commercial Debts (Interest) Act 1998

8. Carbon Trust

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