A credit crisis is otherwise known as a credit crunch or credit squeeze. It refers to a decrease in the general accessibility of credit; it may also be used to refer to an abrupt tightening of stipulations necessary to acquire loans from commercial banks. The reduction in the availability of credit can be a direct result of numerous factors which include, rise in perception of possible risk on the side of the lending institutions like banks, and imposed credit control, and/or a sharp restraint of the supply of money. In most cases credit crises go along with a flight to quality by the lending institutions and investors; they instead seek to venture into less risky investments (Röpke 33). The reasons banks may decide to slow down or stop their lending activities emanate from both endogenous and exogenous factors. Credit crises can be one of the factors which lead to the winding up of companies and big corporations due to insolvency arising from lack of sufficient funds to service debt obligations (Aldridge 263).
The onset of credit crises may be contributed to by a decrease in market prices of assets whose previous prices were ceiling high. The credit crunch is a crisis that can be contained if early warnings are heeded too. It seems that the players in the financial sector did not take seriously the warnings that were given by economic experts on the imminent credit crises. The warning signs will most likely be overlooked in future cases of imminent credit crunch unless the fundamental imperfections in the financial system are properly addressed. The recent credit crisis is, therefore, a representation of the disintegration of the intertwining set of pacts by which the global economy has been managed ever since 1980. These pacts could only offer a short-term resolution to the capitalist crises which had arisen a decade earlier. The world economic system failed to provide precautionary solutions to the recent crises. It seems that the system believed the measures put into place in the mid-1980s were able to shield it from another possible credit crunch (Broadman 283).
The credit crunch has very serious effects on the world’s economy. It has the effect of slowing down economic activities in the world. Some of the negative impacts include loss of jobs as corporations and companies decide to lay off workers to reduce production and operation costs, temporary liquidation or complete winding up of insolvent business entities, and reduced general spending in the global private sector. The credit crunch has a domino effect; its occurrence in one region has a high potential of spreading to other regions with similar effects. This is because the world economies are interdependent (Beenhakker 138).
The Root Causes of Credit Crisis
The fundamental development of the recent credit crisis has been a theatrical worsening of the financial system by which the global economy has been governed for the past more than twenty years, the fundamental incongruity within capitalism linking profit creation within the realm of production and the achievement of the profits within the realm of distribution and exchange. This incongruity within capitalism has led to the accumulation of debts hence resulting in a financial crisis. This is coupled with the acknowledgment that the level of bad debt in the financial system was much larger than previously assumed. This scenario directed the United States government authorities into confusion as regards the rate at which the number of loan defaults was increasing. The high rate of default could be attributed to the credit crisis that had already taken its routes into the whole financial system (International Monetary Fund 29).
The credit crunch was actually a direct consequence of the United States’ failure of the mortgage market. The trouble began in 2001 when the United States Federal Reserve resolved to reduce the interest rate to the level of 1%; the main reason to reduce the interest rate to 1% was to prevail over the negative impacts the September 9/11 terrorist events would have on economic growth (Irvin179). This resulted in a massive inflow of money from China and other countries in the Middle East; the outcome of this was an abundance of available credit in the United States’ economy. This meant that Americans could get cheap loans to satisfy their financial needs. Many people, therefore, took loans to buy mortgages leading to a boom in the mortgage market. Many Americans were purchasing their own homes. The economic principle of demand and supply came into play; the prices of houses went up sharply. With time, the lenders ran out of applicants they considered creditworthy and hence extended their lending to risky applicants. In order to attract risky applicants, the lending institutions never required them to prove the sources of their income, provide down payment, and also there was no credit check. The incentives attracted many credit unworthy customers. The result was a high and increasing rate of default on repayment. The lending institutions, therefore, repossessed back the houses in a bid to resell them at higher prices but no buyers were available to purchase the houses. The houses became worthless to the banks and lenders since they could not sell them. The financial system, therefore, started collapsing (Sheldon 147).
The role of the United States dollar in the world economy can be blamed for the financial crises that recently rocked the world economy. After the Second World War, the United States economy remained strong. There followed an agreement the U.S dollar be pegged to the gold and take dominance of the global economy. There was a subsequent growth in the demand for the U.S dollar worldwide. This and the fear of losing the gold stock motivated the United States to adopt the system of floating Exchange Rates at the beginning of the 1970s. To meet the ever-growing demand for the U.S dollar, it printed the currency without any proper regulation put in place. That led to an inflow of goods into the United States of America in exchange for the dollar. The high consumption of imported goods in the States led to the industrial shift of commodity production to the service industry. The influx of money into the United States of America established the perception of Cheap Money leading to plenty of credit that was directed into use in unproductive activities that finally led to the credit crisis (Krehm 177).
The economy of the United States had never adjusted from the negative impacts arising from its trade balance. Despite this fact, the country continued with its high consumption of imported commodities and, as previously discussed, the domestic industrial output also continued to decline. The deficit that existed between the trade balance and the public budget was therefore managed through extensive borrowing, mainly from China. China reinvested its money surpluses in the States, bonds, and treasury bills. This simultaneous scenario contributed to the worsening of the trade deficit and the rise in the public budget deficit in 2007.
One of the greatest contributors to the global credit crisis was the miss-pricing of risks within the financial sector. The agents in the sector, including rating agencies, over-approximate the perceived reduced risks due to innovations in the financial market (Thomas 331). There was over-reliance on market ratings by the regulators of the financial system and the financial market thereby making them become complacent; the chances that the market ratings were flawed is high. The miss-pricing of risks by the regulators was trusted by the sector to an extent that no one bothered to check in view of confirming the true picture of the financials. This contributed to inconsistent financial flows as major borrowers started to default on servicing credit. Again, it is important to note that banks are the major providers of credit services. In a situation where there is a risk, banks always impose certain restrictions on their lending patterns. In case of the recent credit crises, the supervisors of the banks overreacted to the situation by invoking the advisory of 1990 that was sent to commercial banks warning them against advancing unwise real estate loans. The examiners implemented a more conservative concept of what really constitutes a financially healthy bank. The advice by the bank examiners led to the reduced amount of credit available to customers hence contributing to the recently witnessed credit crises.
However, it is important to note that the credit crises in Africa and other developing nations directly emanated from the developed nations, especially the United States of America. The economies of the third world greatly depend on those of the developed countries. Most banks from these countries get their funds from international development banks in order to improve their lending ability. The credit crises in the Western developed nations led to a reduced flow of funds to these banks. The resultant outcome was for the commercial banks in developing countries to reduce the number of credit products in the market. The crunch led to reduction of capital flow into African economies and also reduced remittances by Africans working in the Diaspora. These had direct effect on the financial markets in the African thereby having ripple effects on the banking and financial institution. So we can argue that the factors that led to credit crises in the Western developed countries are different from those in Africa and other parts of developing regions. This can be proven by the fact that while credit crises in the Western nations initially began, the African nations and other developing nations remained relatively economically stable. It was after the crunch became severe in the West that it spread to other parts of the world; and that was as a direct result of effects it had on international business activities. The third world countries depend so much on mainly exporting raw materials and semi-finished products to the developed nations (United Nations 5).
Management of Credit Crisis Risks
Even though the world as a whole, and the United States of America in specific, has not fully recovered from the recent credit crises, there are still ways through which the risks can be managed in the future. There are certain risks issues that financial institutions can tackle in order to prevent the re-occurrence of the recent events in the financial sector. Some of these include:
- The lending institutions should identify the budding risks as early as possible: this is the first step in managing the credit crises risk. The organizations should come up with more improved ways of detecting these risks before they manifest as financially damaging threats; the financial institutions should get to understand their own risk capabilities by modifying their current framework of risk management. There should be thorough analyses on the possibility of risks on every business decision made.
- Establishing a culture of risk awareness: the lending institutions should enhance their risk awareness culture. Risk culture has become one of the essential elements in a company’s risk management strategies. Many firms, especially lending institutions exhibit insufficiencies in this area. Research has proven that most employees of many companies, including the financial institutions, do not comprehend how risk environment can be evaluated for possible risks and their impact; in fact, many top organization leaders do not have proper training on risks management. This is an area that should be prioritized if efficiency for managing future risks related to credit crises is to be achieved;
- In order to make risk management more efficient in the future, it is crucial for lending institutions to align their risk management strategies with their business activities. They should make sure that their vital business activities are appropriately aligned and frequently assessed to determine effectiveness; they can also ensure that they are able to single out and respond to the possible impacts of change both within the internal and external environment. The risk strategy should be aligned with the companies’ goals and objectives, business strategy, incentives, control, and performance metrics;
- The banks and other lending institutions should ensure extreme transparency on their loan packaging procedures, hold up the model, and the actual risks associated with the packages. They should also have high standards of packaging the loans so that they are tradable in a market with transparency;
- Since the U.S dollar is in high global demand, it should not be overlooked when it comes to avoiding the recurrence of the recent credit events. To reduce the number of goods exported to the United States, the U.S should increase its industrial output and reduce its level of imports. This will reduce the over-reliance of exports to the U.S by countries in need of the dollar. Moreover, the dominance of the U.S dollar in the world economy should be reduced through appropriate international monetary policies. If this is taken into the picture, alongside the fact the U.S has not recovered from the negative effects of its trade balance, the risks of the credit crunch will greatly be reduced;
- Taking the case for the United States, the relevant banking authorities are supposed to come in and regulate all the financial brokers and agents within the state; this should be aimed at restraining the perverse incentives they offer to their existing and potential clients. The authorities should also establish standards registrations of property belonging to the brokers and agents. This standardization should apply across all the states. This should also involve a security execution system during the loading process.
- The rating agencies command some influence in the financial sector; they should therefore embark on strategies of regaining credibility by indicating that they are genuinely independent of any form of unprecedented influence and that the whole process of their ratings is completely transparent and can be relied on by the industry players. This should be emphasized where products involved are complex in nature;
- The banks and lending institutions should be stricter than ever in terms of issuing loans to customers. In fact, it should be a policy by these institutions that all loans advanced to borrowers whose credit worth has not been verified must be backed by specific collaterals; the amount advanced should be based on the value of collaterals provided by the borrowers. In this case, the banks and other lending firms should only offer risky incentives to borrowers whose credit worth has been established and trusted;
- The developing nations should come up with strategies of avoiding over-dependence on exporting primary raw materials to developed nations. They should buy capital goods and start processing finished products within their economies. This will camouflage their financial sectors from severe effects of credit crises arising from outside the economies. Most products imported by the developing nations are manufactured from finished raw materials they export to heavily industrialized developed countries.
The Role of Regulatory Scrutiny in the Risk Management Process
The realization of early signs of imminent credit crises and the need to take timely appropriate measures has triggered the need to put in place regulatory scrutiny in the risk management process. The recent credit crunch, from which the world has not yet fully recovered, has underscored the global threat that the shortfalls of liquidity actually causes to both the individual banking institutions and the whole world’s economy (Vestergaard 166). Therefore, establishing regulatory scrutiny in the process of managing the risk factors will effectively enable the reflection of the risks of the companies’ current business undertakings and output; this will also give the true picture of how other market players behave in reaction to the risk factors. The world’s central banks and other commercial banks have experienced disruptive occurrences that have affected the financial market for the past five years. In view of this, if the institutions recognize the need to adopt a new idea of supporting the synchronization of the international principles of risk management, then this will give information on how the active global banks manage liquidity risks. To get this information, it will be appropriate to use a regulatory scrutiny system that has broad-based operations.
The regulatory scrutiny will allow for a proper check on any information that is released for consumption by players in the financial sector. It will also allow for consultations before any information is released. It will also contribute to the performance of the financial institutions in relation to liquidity; in this case, the regulatory authorities will be able to conduct research and appropriately advice all the industry players appropriately; the advantage with this is that all the regulated financial institutions, lenders and regulators get uniformed information on the prevailing financial environment. This can also allow for collective measures by the banks and other lending institutions. With proper regulatory scrutiny in place, it will be possible to effectively spot, conduct evaluation and come up with appropriate mitigation strategy to any possible risk in the credit market (Ryan 33). The increment in the regulatory scrutiny will also assist the banks and lenders to aim at becoming intelligent at risks management.
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