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Credit Crunch Essay

The term Credit crunch is used to describe a sudden reduction in the general ability of credit in terms of loans. It can also be described as the sudden increase in the cost of obtaining a loan from the bank and other lending institutions. Various factors are responsible for such a sudden increase. Anticipated increase in the value of the collaterals used by banks would be a good example of these factors. Another factor is an increase perception of the risk associated and regarding the solvency of other banks in the banking system.

Still, another factor would be the change in monetary conditions such as when the central bank of a country unexpectedly alters its open market operations. For example, when the central bank suddenly increases the interest rates of the reserve requirements of the various banking institutions. In addition, a decision by the central bank to impose direct credit control or instruction to the banks restricting their lending activities would be another strong factor that can lead to credit crunch.

In some cases, institutions may reduce the availability of credit services or they may increase the cost of such facilities or even may be unable to lend any further. This is

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as a result of losses incurred from sour loans and sustained periods of caress and inappropriate lending activities. As such investment capital become hard to obtain the consequence of which is prolonged recession resulting from the shrinking credit supply (Susan, 2005, p. 23). In general, a credit crunch results from a reduction in the market prices of previously over inflated assets and is seen as referring to the financial crisis resulting from the price collapse.

During the upward phase of credit cycle, the prices of assets may experience bouts of frenzied competitive and leveraged bidding thus inducing hyper inflation in the asset market. The consequence of these is a development of a speculative price sudden upsurge. This will then tend to increase money supply in the market economy and stimulation in the overall economic activities which will in turn tend to temporarily raise the economic growth rate of a country not to mention employment (Wako, 2007, p. 24).

Fair value on the other hand as used in economics and in finance is defined as a rational and unbiased estimate of the potential market price of goods and services. In the usage of this term, sticking with the word asset as opposed to goods will be unavoidable in this text. This estimate of the potential market price of an asset will under any circumstances be subject to various factors such as the relative scarcity of the asset, its perceived utility, and its risk characteristics among other things.

In accounting, fair value is used in estimating the market value of an asset one of which the true market value cannot be determined usually due to lack of a properly established market for the asset. Thus in this regard it is used for those assets whose carrying value is based on mark to market valuations. There have been a lot of heated debates with the unfolding of credit crunch and most of these debates have cycled around the role played by fair value and the accounting standards in operation in the market.

Mark to market or fair value has been highly accused of causing credit crunch and the present financial crisis in many countries (Susan, 2005, p. 37). It has been argued that in a down turn fair value has caused bankers to recognize losses. At the same time fair price accounting has been accused of impairing the capital of this bankers and triggering fire sales of assets which in turn drive the prices and the valuations even further down. This as the banks has often argued is causing them to sell assets at a much lower price than that stated as their face value thus giving a discrepancy in the accounting books of the bank.

This discrepancy will without error translate to losses at the end of the banks accounting period. For example, there has been bank complains of selling bond at a much lower value than the face value. This they attribute to the requirement of the fair value accounting whereby they are required as per the accounting standard to assign a market value to their assets rather than using the historical price values of such assets (Scott, 2007, p. 53). Another argument can be formed with respect to the non liquid assets.

The ultimate question then would be how the banks and other companies assign a market value to assets that are non liquid and sometimes unique assets? A common solution to this has been the use of bank’s own model. It has however been argued that this model are known to give bank managers too much unnecessary discretion because these assets are large relative to many banks shrunken market values. It therefore may be impossible to find a generally acceptable method of assigning market value to these assets.

The methods used by various banks is always subjected to the accounting requirements of ‘accounting’ for each and every cent owned by the bank and how such a cent is subjected to use. The banks have therefore placed the argument that the best method then would be to disclose enough information to the investors to allow them to form their own informed views (Susan, 2005, p. 11). The third problem of mark to market valuations as seen by the bankers and other investors is the inconsistency of the fair value rules.

This is usually seen as a long term issue and one that need to be addressed by the financial accounting standards board. The treatment of a financial asset today is determined on the basis of the intention of the company. If the asset then is to be traded actively, its market value is used and if it is only available for sale, it is marked to market on the accounting books. In this case, losses are not recognized in the income statement.

If on the other hand the asset is to be held to maturity, it can be carried at cost subject to impairment. Different banks tend to hold the same asset at different values (Susan, 2005, p. 68). The accounting standards board in response to this has sought to scrap the income statement such that the changes in the value of assets or liabilities are clearly separated from the recurring revenues and costs. Such an action has varying degree of outcomes to the small business sector and the large business sector but in different magnitudes.

To the small or low risk banks, this would make little difference to their operations. On the other hand, this could mean big losses to the more risk taking institutions (Orla, 1998, p. 94). Though evidence has shown that standard setters are now truly independent and focused on investor’s needs rather than the wishes of regulators and the tax man, there exist a need to abandon traditional and mechanistic link between accounting and the adequacy rules if they really have the desire to fight the credit crunch crisis.

It has also been argued that when a market disappears or where there exists no market, companies bear the burden of using complex mathematical models to come up with values that can be confusing to the would be investors (Wako, 2007, p. 29). Critics of fair value has also argued that fair value create life votality. This has been seen as reducing the prices of stocks. The same critics argue that the approach of fair value accounting creates distortions when markets are dysfunctional.

Bankers fear that the system of fair value accounting is making the credit crunch crisis worse by forcing them and hedge funds to sell assets in a manner that is stocking investors panic. This arises from the fact that institutions have for long been using different models for assets such as loans that they tend to hold until maturity thus allowing them to ignore irrelevant market fluctuations(Scott, 2007, p. 81). The argument further holds that are entangled to the fair value net partly due to changes in accounting rules and partly due to the new business models.

In this regard, banks have embraced ‘originate and distribute’ model as it is known in which they pass on the risk of the loans they make, by packaging them into marketable securities. The banks therefore have swapped the credit risk of holding such loans for the votality risk inherent in any tradable financial instrument. The value of mortgages and that of portfolios has tumbled over in the recent times wounding the balance sheets of many institutions and also have a direct profound effect on the profits realized by these institutions (Peter, 2006, p.

35). On the worse side, “mark to market” accounting has encountered many practical challenges. The intellectual framework supporting the creation of complex derivatives and application of fair value concepts has tended to assume that capital markets have reached a level of sophistication meaning that they are unlikely to ever freeze up too widely or for too long. The amount of the resulting panic in the credit world has become magnified such that buyers have disappeared thus making it extremely hard to get genuine trading prices.

This has in turn created a dilemma for the bankers and their auditors who have been trained to view the market as the ultimate independent arbiter. Some accounts in dealing with this have adopted various methods. Some have scoured the markets looking for evidence of deals that could be used in determining quasi-market prices. For example, many mortgage-linked securities are currently being valued on the accounting books of the banks not according to their actual price, but rather from an over stated value taken from associated derivatives.

Derivatives indices such as the ABX are creations of the recent past and thus, they tend to be highly volatile. The argument here has been that some of the ‘market’ prices used by the auditors offer a poor guide to intrinsic value, that the current write-downs will certainly be reversed in the future (Orla, 1998, p. 77). Another problem created by the fair value accounting system is the difficulty in placing assets in the so called level three category.

A general requirement of the regulators to the bankers is that banks should hold high reserves against those assets in the accounting basket. As a result, the movement of more assets in this ‘basket’ increases capital pressure on the banks. This goes to add to the write-offs that they make on the assets that can be valued. This has over the time threatened to create a vicious cycle in the economic market. The resultant force of this pressure to improve credit rations is that banks have opted to try and cut their lending to heavy borrowing counterparties such as the hedge funds.

In this regard funds are forced to into fire-sales to meet calls on one hand and if they collapse as witnessed in some of the institutions, then the banks tend to take control of the remaining assets and then liquidate them on the other hand. In either case, the sales continue to depress the prices and in return, reduces the recorded value of the banks’ assets and goes a long way in increasing the pressure on these banks to reduce lending even further down (Scott, 2007, p. 107).

In conclusion, many policy makers and financial analysts hold the view that a wider debate is needed to examine the way in which fair value accounting rules are being applied in the financial world. Indeed, some of the concerned institutions are already discussing potential reforms with an increased effort to include the accounting standard board in each step. This economic institutions have also increased their pressure on the board the each the requirements thus to facilitate a decline of losses realized. Reference

Orla O’Sullivan (1998) “125” Loans: A Reserve Credit Crunch. ABA Banking Journal, Vol. 90, pp. 77, 94 Peter Bryan (2006) Principles of Financial Management. London, Routledge, pp. 11, 35 Scott Anderson (2007) How a Liquidity Crisis Becomes a Credit Crunch. ABA Banking Journal, Vol. 99, pp. 53, 81, 107 Susan Daniela (2005) Fundamental Instabilities in the Money Market, New York Allen and Unwin Sons, pp. 23, 37, 68 Wako Wanatabe (2007) Prudential Regulation and the “Credit Crunch”: Evidence of Japan. Journal of Money, Credit and Banking, Vol. 39, pp. 24, 29

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