Acredit squeezeorcredit crisis

Acredit crunchalso known as acredit squeezeorcredit crisis, is a decline in the general availability ofloansorcredit, or an unexpected tightening of the prerequisites to obtain aloanfrom thebanks. A credit crunch normally involves a fall in the availability ofcreditindependent or a rise in officialinterest rates.

  1. Financial institutions such as banks and building societies slash the amount that they are prepared to lend to each other .This is known as a decline in inter-bank lending.
  2. The drop in the supply of credit leads to a rise in inter-bank interest rates e.g. in the UK we have seen the LIBOR rate move well above the UK bank base rate set by the Monetary Policy Committee.
  3. This increase in interest rates leads to higher interest rates on mortgages and credit cards. This makes borrowing more expensive for ordinary people and for homeowners.
  4. It can also make it very difficult for businesses to raise fresh capital through bond issues, forcing a lot of them to look to the stock markets for streams of new capital e.g. by making use of rights issues.
  5. The crunch involves a draining of liquidity in the financial system.

The credit crunch started in August 2007 when the rapid expansion of bank lending and credit to sub-prime borrowers. Underpinned by banks mortgaging their debt in often opaque packages, came to a stop. The market all of a sudden lost confidence in the capacity of these borrowers to repay their loans, and with that the confidence loss of retail was lost. It was uncertain about the ability of institutions to repay their debts in turn.

In the UK, Northern Rock was the first financial institution to experience severe difficulties. Its funding model suddenly became unsustainable and the Government was forced to intervene to guarantee deposits.

As central banks decided to ease monetary policy, banks wanted to tidy up their balance sheets, tough lending criteria and widening spreads. A number of banks received guarantees or were herded towards mergers but when Lehman Brothers went into receivership in September 2008, the pressures on the banking industry grew intense and were met both by huge central bank injections of liquidity and in several countries, especially the UK and US, direct government support. In the case of the UK, two from four major clearing banks, RBS and Lloyds groups were nationalized. Of the other two HSBC has much less exposure to "toxic debt" and has been able to retain its independence and raise equity from the stock markets to build up its balance sheet. Barclays raised funds from a series of strategic investors in the middle and has sold businesses such as "ishares" and "Barclays Global Investors".

Overall lending issues.

Each of the major UK banks are ready to lend and generally the data claims that they are lending but some institutions, particularly overseas banks have exited the UK market altogether. The best example for this is Icelandic banks. Secondly the demand for new lending as against to distressed lending at a price which banks want to lend at does not appear to be there. When it comes to reassessing loans to existing clients, banks are faced with difficult decisions when their clients are stressed as to whether they try to manage the state of affairs or risk pushing a business over the limit. Finally but most importantly banks willingness to lend varies from sector to sector as different banks have different levels of exposure in different areas, for e.g. most of the clearance banks have high exposure to London property development and so are reluctant to make new loans without substantial levels of equity.

Government expects the banks to increase its lending but banks' stakeholders want to rebuild their balance sheets. There is stress between the systemic objectives of shrinking reserves when the economy as a whole needs liquidity; and the interests of individual institutions. Government wants the banks to lend more but the past year has shown that people take their capital out of institutions which look susceptible because they have low capital ratios.

Credit is only accessible at a price as well as some institutions lending unwisely, most were lending at indefensibly low rates and margins. While bank base rates have come down considerably across the globe and reaching record lows in the UK. Spreads have widened, signifying both a more realistic pricing of risk and the need to uphold higher than base rates for retail savers.

The process is tougher. There is indication to suggest that at least some clearers have limited the lending authority of many managers and have centralised decision making that might previously have occurred at local level. Definitely a lot more decisions are being referred to management than what it used to be the before. The basic approach has been adopted in an attempt enhance returns and lending quality. But this approach towards business would manifests itself to a tough negotiating tactics. This centralization approach and toughening of the process has resulted in the requirement of personal guarantees for very small loans to SMEs. This leads to the choking off credits they don't want or losing good business they might otherwise have had. There is also a unwillingness to participate in dull and low return stand-by facilities. Some banks apparently have a centrally dictated list of approved sectors, and will not entertain business from the unapproved sectors however good the risk profile may be.

Alternative capital sources are comparatively attractive. As equity is the better option as a source of capital, so too is wholesale debt, with companies increasingly looking to become debt rated so they can raise money directly from the wholesale market.

It is very evident that the Credit Crisis has led to exceptional government participation in the financial systems of the complex market economies and that this poses significant increase in risk factor to public finances. In addition risks come from the present global economic meltdown. While the twin crises create the precondition for an overdue reform of both national and international financial and public finance regimes.

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