The global credit system and analysis of credit crunch
The Fractional Banking Systems and its operation
The banking system operates on the fractional reserve system whereby banks are required to maintain a part of the cash deposits with them as a reserve. This is also called cash reserve ratios of CRR and this ensures that banks have enough cash to meet the requirement of withdrawal and also that it does not lend too much. This concept can be better understood with the help of cash multiplier effect or velocity of money (VM).
When someone deposit a Rs. 100.00 in banks, and bank has a 25% CRR, it is allowed to lend Rs.75 to its client/customer which in turn deposit this money to its own account which is further used to lend the money to another customer to the extent of 0.75 of 75=Rs 60. This process goes on until the last borrower of the banks gets the loan and in this way and total money creation will be
∑ Initial Deposit (D)/(1-CRR) )^n,
where n=number of time this borrowing and lending process continues. In another words, the money multiplier M is the inverse of the reserve ratio CRR i.e.M = 1/CRR.
Now as we understand the banking system of lending and how that result in growth of economy, we can understand the importance of credit system. However, there are two more ways, a government can influence the money supply. Firstly, it can buy back the treasury notes by creating and circulating more money in economy directly. Secondly, it can decrease the overnight lending and borrowing rate. We have seen that when economy overheats financial and banking regulator such Reserve Bank of India will increase the interest rate to make the money costlier to buy, not to forget interest is the price of money.
The origin of Credit Crunch
Now the question arises as to why the credit crunch happens and what happens after that. This article will analyse the factor which will directly impacts the credit system and availability of cash discussed above.
Normally a developing country, which has by and large a very risk averse banking system, most of the time does not cause the financial distress for itself, nevertheless, it faces fianancial distress as a ripple effect of the financial Tsunami in most of the developed and industrialized nations. This is true despite some much publicized ‘decoupling effect’ and the reduction of economic correlation between the developed and developing nations. Therefore, we need to look into what happened in most active capital markets and why they fall into trouble to understand the credit crunch in the rest of the world too. After all, we are in a globalised, flat world and we are so interconnected.
( a ) Creation of bubble
The best point to start will be the analysis of the latest financial crisis since 2007, as it is still fresh in our mind. While I am taking a risk of sounding too pessimistic , I would like to disagree with the popular notion that the financial crisis we witnessed in 2007 is over, in fact it was just a ‘W’shape pseudo-recovery in 2010.
Let us remember the financial politics in USA, going back to the start of last decade, when George W Bush had started his presidentship with a vision of ‘house for everyone’. No doubt this was a great vision but it was implemented without adequate preparation and the banks started to support this by extending the credit to undeserving creditors to buy houses. ‘Undeserving’ because many, if not mostly, did not have the enough creditworthiness to buy the houses they opted for and banks in their pursuit of expanding the business turned blind eyes to this issue.
As a consequence of the abovementioned policy, hundreds of thousands of houses were purchased by banks for their customers in return of hope for the constant stream of cash flow from the customers. Banks were supposed to get the trillions of dollar in next 30-40 years but it was too long a span to wait for such a huge sum of money, hence they decided to sell this stream of cash flow in the form of Mortgage Backed Security (MBS) and Asset Backed Securities (ABS) and to make it more lucrative they offered this in the form of different tranches to suit various types of investors and their investment preference. Now to make this situation worse, this MBS & ABS tranches were given credit ratings and more interestingly the fees were also paid by the same banks who were issuing the financial products.
(b ) A biased Credit rating in favour of borrowers
Not surprising that there were conflict of interest in the issuance of credit ratings by the ratings agencies such as S&P,Moody etc. Ultimately, their clients had to be pleased with their outcome of investigations, so the independence of the ratings need not be commented here. Anyway, with some of the AAA, and AA ratings, which are considered good investments, many risky financial derivative products based on the mortgage payment sold like hot cake. As expected this improved the money circulation and confidence level greatly in the economy. Everyone was getting home, banks were earning good commission, bankers getting good bonuses, tons of new derivatives products were created and sold to naïve investors, and this increased the Velocity of Money and increased the available credit in the market. This resulted into expansion of GDP too. Everything was going great until some house owners realized that the house they had bought is not worth the payment because they had bought the house at a much higher price than it should be thanks to widespread availability of credit or when they realized they can not make the payment due to limited financial resources anymore. Then few defaults happened, and this continued. This created panick in the market because each one default was going to impact dozens of investors apart from the banks, as so many derivatives were created, bought and sold based on one single stream of payment. This derivatives too changed hands so many times that many investors would incur a loss if the mortgage payments does not come on time.
(c ). Excessive liquidity: Excessive liquidity causes the overheating of economies which increase in the inflation to the extent where the saving becomes uneconomic and the benefit of utilizing the money now becomes more worthwhile than investing into the business for return in future. While some economies tried to provide more cash for investment in different infrastructures, which is also called ‘quantitative easing’ by way of easy monetary policy, they went too far away while liquidating the cash-starved economies. Apart from this, financial innovation such as credit-cards and financial liberalization at the start of 2000, also exponentially increased the access to cash for every stakeholders in major economies. When the cash flows in excess of the growth in GDP, the wildfire of overconfidence takes over the entire capital market and destroy it to ashes, by creating an illusion of false value in the financial products.
How the credit crunch starts and spreads
Taking the previously discussed scenario further, it is expected that, in case of defaults, the banks had no way but to seize the houses and put them for the sale in open market but at that point it was too obvious that the houses were not the worth the price. So banks either could not sell the property or sold at a very lower price as a distressed asset. This resulted in widespread devaluation of financial instruments and derivatives based on the payment from the cash flow based on this defaulted mortgage payment. This situation together with other defaults on credit based derivatives led to collapse of Lehman Brothers, Fennie Mae, Fried Mac and AIG etc. Rest of the situations we know. Consequently one of the greatest financial Tsunami struck all of us.
AT the start of 2007, British Bank HSBC declared its losses at its US branches, mainly due to the exposures relating to mortgage loans. Sooner than later, the New Century Financial saw its stock prices plummeting by over 80% and Bear Sterns Hedge Fund went into troubles caused by its investments into the CDOs.
It is important to note that the above process of lending and default was not only due to mortgage and in the USA, in fact, it was happening in various forms in many other countries too with the same implications.
As an aftermath of the above situations, the whole economy went in a recessionary cycle, credit dried, interest rate rose, and investors were too cautious and became paranoid in some cases. It never happened that suddenly the wealth of the world disappeared or the treasury was not able to print more money, the biggest problem was that investors did not have the confidence. It is the confidence in the economy and market which had made the credit available while ‘party was going on’ but after the series of defaults the confidence disappeared and the credit market dried up. This is what is known as credit crunch. Probably this will be too simplified explanation of credit crunch, however, it is certainly the process which creates the bubble and at its peak when the bubble bursts, the recession and the credit crunch follow.
There are many more reasons behind the credit crunch as well. Weak corporate governance coupled with too flexible and inappropriate accounting standards also take away the faith of investors. To make it worse, the global financial machinery is also to blame which allows excessive risk taking and promotes the agency issues whereby the bankers can take high risk to get rewarded in the short term but does not take a prudent approach. Certainly the regulations have been too reactive in financial sectors, as the Sarbanes Oxley followed by Enron fall out, Basel III & Frank Dodd act after the recent financial turmoil only shows that the regulations are only backward looking and they are not able to prevent the disasters from happening and thus are not proactive in nature. Every time a new type of issue fails the market and therefore the acts which try to stop the repetition of old issues are not enough.
The curse of Credit crunch: Opening of the Pandora’s Box
The typical symptoms of credit crunch are jittery stock market, collapsing housing market, frozen credit market, global bank losses, rising credit spreads and rising commodity prices. If the interest rate goes up in the wake up credit crunch, the market will be required to give higher return and hence it starts loosing the attraction. Similarly the housing loan becomes from expensive, for two reasons; first that the economic downturn increase risk factors and second that the credit shortage make interest rate high for mortgage loans.
This is only the tip of the Iceberg
Ways to ward off the Credit crunch risk and its impacts:
1. The long term cures for the credit crunch are the steps which will act against the factors discussed above which encourages it. For example, the usage of derivatives should be restricted and must have a sound reason behind it to reduce the reckless trading of them.
2. Also the accounting standard should be more holistic which could reflect the risk of the corporate in much more clearly. The strict compliance to corporate governance is must to increase the confidence index in market as the fear of poor corporate governance make people stay away from investments.
3. The remuneration of the top bank executives should be under scanner and should be tied to long term financial well being of companies, so that bankers do not take excessive risks for short term gain.
4. The Corporate Governance code and compliance standard must be stringent enough to enforce the compliance in order to sustain and bring back the investor and market confidence by increasing the transparency and promoting a fair business dealings so that investors can bet the money without fear of a big collapse. This will help keep the money flowing. The lack of investor confidence, not the scarcity of capital, is what the breeding ground of illiquidity and credit crisis is.
5. Last, but not the least, the government fiscal discipline and a conservative approach of printing money is also essential to keep the inflation in control which will give the investor the incentive to invest money in the market. Additionally, excessive government borrowing caused by unnecessary spending shoot up the cost of borrowing in market which is also responsible for lack of credit available I the market.
A robust risk management policy and strict adherence to it is warranted post credit crunch crisis and Investment Managers should be mindful of the fact that the exotic derivative products may not be accurately categorized under the suitable credit rating.
