Napier University

Msc Accounting and Finance

Module – Finance management

Student no - 08010819
Module no – ACC11105
Introduction

The purpose of this easy is to discuss “whether the credit crisis has caused by

the banks reporting high inflated profit in the last financial year, and paying

inflated bonuses to the top management”. It analyses the past situation of

financial market and also examine whether the above statement is true or not?

In present time the credit crunch or the credit crisis is very crucial issue for the

financial sector. The credit crunch has arisen due to the careless and

inappropriate lending practice of the financial institutions and other credit

providers. In this condition lenders reduce lending money to make themselves

safe from bankruptcies and default risk and increase their interest rates to

minimize the risk associated. In other word due the shortage of funds these

financial institutions face liquidity problem and become unable to lend money

to customers and also each other because of risk factor of default.

Over current years the term ‘credit crunch’ has been an all very common one

in the UK and globally. In this situation banks and lenders suddenly reduce

the availability of credit or loan to minimize their risk. In this circumstance

banks and other lenders also increase the cost of acquiring credit and also

increasing interest rates. The credit crunch is normally a period of soft

recession because money stuck in the dept and not available immediately.

BACKGROUND TO THE STUDY

The recent credit crunch commenced in august 2007 in the us sub prime

mortgage and when borrowers became defaulters then it start effecting to

other counties like Europe, Asia, Australia, and other countries. There is not

one reason of the credit crunch in the UK but there are multiple factors which

have cause the credit crunch such as the sub prime mortgage, lax lending,

decline in bank capital, fear of risk default and increasing interest rates.

In 2008, Wallace, Avis, and Smith say exactly the credit crunch is a situation

when borrowing money comes at a higher interest and borrower has to pay

higher cost. Similarly, in 1994 Kaufman explains back in the 1960s, I have

introduced the term ‘credit crunch’ to explain a sudden shortage in the flow of

credit. Clair and Tucker (1993) argue that many bankers, legislators,

Borrowers, regulators and economists have expressed their views about the

causes of the credit crunch and each has described the problem and potential

solutions differently. Wallace and Smith (2008) state that definitely, subprime

mortgages are main causes in the ongoing credit crunch and they also add

that there is not the only contributor to the problem. In reality, the credit crunch

is the end result of lax lending by the banks and lenders in spite of this

consumers spending beyond their earnings for way too long.

Bernanke and Lown (1991) define the credit crunch as a decline in the supply

of credit that is unusually large for a given period of the business cycle. Credit

normally decreases during a recession, but an unusually large contraction

could be seen as the credit crunch. Wallace, Avis, and Smith (2008) Say
literally the credit crunch is a time when borrowing money comes at a higher

risk and a higher cost.

ANALYSES OF THE STATEMENT

The statements says credit is the result of high inflated profit of bank and high

bonuses to top management, to evaluate this statement will check start of

recent credit crunch. The recent credit crunch commence in august 2007 in

the US sub prime mortgage and when borrowers became defaulters then it

start effecting to other counties like Europe , Asia , Australia, and other

countries.

“Whether the credit crisis has caused by the banks reporting high inflated

profit in the last financial year, and paying inflated bonuses to the top

management”.

Previous study showed There is not one reason of the credit crunch in uk but

there are multiple factor which has cause there, like to get sub prime

mortgage, lax lending, decline in bank capital, fear of risk defaulters, increase

interest rates and liquidity problems. Among these sub prime mortgage of US

and UK is considered most responsible factor.

The subprime means the borrower who does not meet the criteria for prime

mortgage rates because this borrower has not good credit history and in this

situation the chance of default is high or they may fail to pay their monthly

instalment of loan, thus to reduce risk bank charge high interest rate.
According to Wharton professor Todd Sinai most subprime loans start with a

low teaser rate for first one to three years and after than bank reset the rate

and some time this rate increase by 50% or more and because of this

borrower face the problems to repay their loan or raise the rate of delinquent

payment, so lender was not willing to lend and this situation introduced credit

crunch in the economy.

Many banker trace the origin of current financial crisis and find out that US

subprime is the major cause of credit crunch than is also enter in UK financial

system. In past Wall Street convert newly issued mortgage in to security that

called mortgage-backed securities (MBS) is the vehicle that has enabled the

globalisation and socialisation of US mortgage supply and default risk.

Many financial institutes in UK like banks and other financial investors

invested billions of pounds in US subprime mortgage like MBS with

expectation of high profit at low risk but in 2007 bursting of US housing

bubble, UK investor had to sustain heavy loss in their investment. according to

one report of Yalman Onaran that subprime asset write-downs and credit

losses at more than 100 of the world’s biggest banks and securities firms, in

which including losses of US$19.5 billion in HSBC, US$15.2 billion in RBS,

US$7 billion in HBOS, US$6.3 billion in Barclays, US$ 2.7 billion in Lloyds

TSB, so in this way total loss reached at US$396 billion. And this situation

formed instability in the financial market.

Other reason is lax lending and decline in bank capital. This is one of the

most responsible reason for the credit crunch in UK financial sectors. Because

banks and other lending institution’s financial report and data shows that when

there was no money crisis, the lending figure of banks ware so high. They

provided loan to that borrower who did not meet the criteria of prime mortgage

and to consumers with poor credit history, But as the shortage of credit or

liquidity started the heavy loss happened due to defaults and payment

delinquencies. And this situation stimulated the capital or liquidity shortage

and consequently this self-destructive cycle generate slowing economy,

overall falling stocks, increasing fuel prices, stagnant to negative job growth,

the housing market slowdown, and, the subprime mortgage disaster and all

these have led to credit crunch in financial system.

But the statement says that bank reporting high inflated profit in the last

financial year, how it’s created by the banks? It can be seen that the income

statement of different banks of last financial year that there was high profit
generated different banks, like Lloyds TSB reported £3.8 billions pre tax profit

in 2007, which was 17% more than 2006. same HSBC £11.5bn , Royal bank

of Scotland which owns Net West earned £9.3bn, Barclays 6.8bn and Halifax

owns HBOS £5.4bn. In one estimation the combine profit of all UK bank was

more then £40 billion for last year.

This profit was generated by investment in sub prime mortgages in US and UK

and lax landing to the high risky borrows. In past many bank , and investors

invested a lot in US sub prime mortgage like (MBS) mortgage back security,

which emphasis on securitization with good yield on investment. This was

tradable in the open markets. These securities depended on the cash flows

coming during every month, with no missed payments or mortgage defaults.

And other side lax lending or easy loan was the one reason of high profit. In

which bank and other lending institution was lending to sub prime at high

interest at high risk At process of lending banks ignored the income situation

of borrower and capacity of pay back of loan and instalment of loan.

In 2007 most of banks and lending institute generate inflated profit by not

properly considering possibility of bad dept or defaulter. They did not make

proper provision of bad dept or they show the less depreciation than actually

should be. In other word banks and lenders were so optimistic about their

landing policies. Other side in the duration of this high level profit some bank

used their capital to acquire other financial instates or banks like Barclays buy

ABN AMRO with the offer of £91 billion. This kind of deal block big number of

capital of any bank. Other matter is bonus last year many bank paid quite big
amount to their top management like Barclays executive Bob Diamond got his

pay and bonus 21 million pound. And in April city banks workers received

£16bn as their bonus which was same as 2007.in this way, the total bonus of

financial sector was £28bn which is quite big amount. All this kind of out flow

of liquid capital create the shortage or decline in the capital in the bank.

So in credit crunch financial situation became more worst when housing

bubble busted and because of critical situation of sub prime mortgages UK

bank and other investors has to sustain loss in their investment. Other hand

lax landing to sub primes borrowers at high interest and when mortgage

borrowers had to switch from their initial low fixed rate payments to higher

variable rates, they faced difficulties to pay their instalments. And this increase

intensity of defaults and delinquencies, thus result of this situation was decline

in security of sub prime loan so investor loosed their confidence and assumed

that they will loss their money. So they reduced lending at high risk. And this

whole situation created credit crunch in the money market.

In the credit crunch every causes and reason is linked with each other. Below

diagram help us to understand the whole linkage from start of credit crunch to

current time.
So credit crunch started in US. Nobody could guess that housing problem in

US can affect the borrowers of UK economy. Last year there was rapid growth

in financial market in US and UK and banks ware keen to lend. With this

intention they target the borrowers who did not have their own houses or

property and offer them cheap and easy introductory mortgage at low interest

rate which called sub prime mortgage. After that mortgage were sold to other

bank and investors in the world through (MBS). When ownership got changed

this new security holder increased interest rate and borrowers got problems

with instalment. During this house prices stared falling and investors realised

the risk and minimize landing. From this stage credit crunch shows its

presence, in UK northern rock was the first British bank who became victim

because it was not able to borrow money from wholesale market for business

and lending activities. Because of this northern rock immediate needed money

from bank of England. As this news came out in society, people got afraid and
started withdrawing their money and large of deposits from the banks. As

result it create liquidity and capital shortage in monitory market. Other side in

US house prices constantly falling down and mortgage holder and borrower

hand over house keys to lender institutes. So bank and other investor had to

suffer loss of billion pounds. After this banks were more reluctant to lend

money to rebuilt their finance but with higher interest rate and without high

risk. So people started facing difficulties to get credit from the banks. And

credit crunch became so impact full in world of financial market.

In recent finance market there are sharp fall in the profit of almost all the

banks like Barclays declared 33% in their profit with 2.75bn compared with

4.1bn for same period of last year. HSBC’s profit drop by 28% compared then

last year. Alliance & Leicester drop with 99% in their profit and reported interim

pre-tax profits of £2m, down from £290m. HBOS declared 72% fall in their pre

tax profit. And Lloyds TSB shows 70% decline of first six month profit in this

year.

Conclusion

From the above study it has now been clear that the current credit crises is not

fully resulted by the banks reporting the inflated profit in the last financial year,

and paying inflated bonuses to the top management. Of course these factors

have played role in the credit crunch but profit is the result of that activities. In

last years by investing in sub prime mortgage and lax lending at high interest

lending banks generated high profit. And about high bonuses, that is
depending on profit. So it can not be main reason of the credit crunch. The

previous research and study has shown that the credit crunch is the result of

multiple factors those negatively affecting financial institutions, capability to

provide credit. While financial institutions are unable to deal with these factors

efficiently at the same time. Those multiple factors are lax lending, liquidity

problem, financial market uncertainty, investors loosing their confidence, and

subprime mortgage market crisis.

References

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Review—Third Quarter 1993, page 1-20, Federal Reserve Bank of Dallas,
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Bernanke, B. S., & Lown, C. S. (1991), “The Credit Crunch”, Brookings Papers
on Economic Activity, Issue no. 2: p.205–248

Wallace, J., Avis, M. A., Smith, S. C. (2008),”The Credit Crunch: A Domino

Effect” Business Perspectives (MEMPHIS), Bureau of Business and
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