The credit crunch which is also known as a credit crisis, finance crunch or credit squeeze is best described as a condition that makes investment capital hard or difficult to obtain. It is the sudden reduction in the availability of credit and loans or the abrupt tightening of loan borrowing conditions by financial institutions. Therefore credit crunch is generally associated with reduced credit availability although it might be independent of interest rates increase.
During this period investors and lenders seek investments that they consider to be less risky and make flight to quality. This is usually at the expense and disadvantage of medium and small sized business enterprises. The price of liability and debt products is therefore driven up by the wariness of the banks and investors to lend money to corporations. The credit crunch condition is usually considered as a product or an extension of recessions.
What causes credit crunch The sudden wariness of banks and other investors to lend to corporations may be the result of a variety of reasons. First and foremost the slow lending activity could be as a consequence of the central government imposing or forcing direct credit controls on banks and the banking system in general. It could also be the product of banks anticipation decline with regard to the collateral value used they used to secure their loans. Additionally it could be a result of an unexpected raise in reserve requirements or other monetary conditions by the central bank.
Moreover perceived increase in risks concerning the solvency of lending institutions within the system of banking could also cause a slow down in lending activity. Credit crunches could also be the effect of sustained periods of careless lending that consequently leads to losses and huge bad debts for investors. The institutions are then forced to react by raising interest rates and decreasing credits that can be made available for lending purposes. Because of the losses that these institutions and investors had earlier incurred it becomes hard for them to lend further than the fixed levels even if they wished to do so.
The crunch can also be generally as a result of a decline in the prices or value of assets that had been previously over inflated. The price collapse then substantially leads to a financial crisis. Consequently new entrepreneurs or investors in the market may be forced to foreclosure or bankruptcy as the values of the assets that had been previously inflated go down. In the event of credit crunch especially if the capital available will not be sufficient to survive the credit cycle businesses may prefer to go into liquidation, sell or mark to market.
Credit crunch occurs in cycles. During its upward phase assets can experience leverage bidding and induced inflation in prices. Effects of credit crunch on the economy. Generally the crunch has acted to decrease economic growth by disabling major industries and key factors of production which are important to ensure a thriving economy. The credit crunch has not only affected the financial markets in the country but it has gone ahead to affect the ordinary customer and consumer who usually support and also benefit from a booming economy.
The credit crunch in the United Kingdom has basically meant that customers are experiencing an increase in the rates and fees charged to them by banks and other financial institutions. For the customer more security is required in cases where the individuals want to take new loans or make overdrafts. For suppliers the situation remains the same with equipment loans getting even harder to acquire and overdrafts being called in or basically being reduced. The rates offered by the financial institutions have soared way past most suppliers’ capabilities and guarantees and debentures have become the order of the day (OL 2007, 2-4).
The increased lending rates have resulted to restricted people spending and have also left individuals at a loss not knowing from which other sources to tap their finances. Additionally the economy’s supply capacity has been dramatically affected. The economy’s potential output has been reduced leading to a shortage of goods and services. This also means that the ability to produce innovative goods and services has also been deterred as this also depends on lending services provided by financial institutions that are incapable of lending out enough at the moment.
Lack of profitability as a result of reduced innovation has thus become a norm leading to a further economic slowdown. The economy has been deeply affected also because investor confidence and trust in the financial markets has gone down. This means profitable business has ceased and that making losses has become the norm for the economy the implication being deficits in the government budget. More so as a consequence the public sector has gone into deficits (BBC News 2008, 3-5).
This is a devastating situation for the economy after enjoying not less than fifteen years of economic growth. Big financial firms have been forced to closure or have had to be rescued with massive damage having been experienced on their banks balance sheets. Investment banks have recorded major losses in their financial books and further aggravated by the decline of structured credit values. Money markets short term lending has become way too expensive and the medium period unsecured lending and securitization which were among the key sources of funds for financial have dried up.
Most companies have additionally been forced to direct their income towards debts servicing. The effects have been contracted earnings and increased unemployment rates as companies struggle to cut costs. So far the largest job cuts and unemployment rates have been recorded in the housing and financing sector. In fact towards the end of this year the rates are expected to shoot to five percent which is double the figure that was previously recorded during the end of 2007.
The labor market has since been weakened as the result of the crunch as more people get out of working capacities. The housing market is among the worst hit and has continued to weaken as the crunch proceeds. The prices in this market have fallen to devastating levels leading to a further decline of employment rates and real income. Obviously the investments in this sector have gone to a record low. Mortgage rates have also increased, its lending decreased and thus pushing the house prices down.
The housing sector is in fact expected to experience a 24 percent drop this year (Pritchard 2009, 3-6). What Is Being Done? Over the last months the economy of the country has declined by a figure not less than 0. 8% making it even harder for the government to map out the way to recovery (Channel 4 News 2009, 1-5). Despite the governments efforts to revive and redeem the people and economy from the disastrous effects of the credit crunch most citizens are not yet satisfied and they are in fact of the opinion that very little is being done to fix the situation.
The general feeling is that politicians have been merely throwing words at each other and therefore failing to turn their words into significant action. The government despite these feeling from the public is trying all it can to undo the damage, for example the Prime minister has been caught encouraging people to strive to pay their debts instead of overspending on some household commodities like food. The government is therefore trying to encourage its citizens to ensure that they have enough funds in store to clear or pay their debts and loans.
This is for the reason that the more people are able to clear the amounts of money they owe as loans the easier it will be for the credit crunch to fade away after some time. Additionally people are being encouraged to take loans that have rates that they will be able to afford. This is because if people keep up the habit of borrowing loans with high rates and therefore unaffordable to them, the worse the credit crunch situation is going to be.
Taking up loans with higher interest rates only create greater debts for lenders because people eventually end up struggling to pay or not paying at all, the effect will then be a prolonged credit crunch (Gillepse 2009, 5-7) Additionally the government opted to increase guarantee on savings in order to discourage or stop mass withdrawals of financial institutions. The implication is that savers have their first not less than 35,000 pounds guaranteed in full unlike the previous years where only savings of not more than 2000 pounds would be guaranteed in full.
The government in addition made various attempts to maintain interest rates and keep them on hold for a while due to the turmoil in the economy. They have also severally in the past year cut the rates with the aim of easing the situation, trying to bring it under control and to assist borrowers. The government has moreover tried to persuade its citizens to stay clear of overvalued assets which are all hostage within the credit cycle such quartet resources include for example those in the travel, chemicals and construction industries.
The government has also tried to carry out systemic injections in an effort to help fix the crisis. It has furthermore tried to come up with various rescue packages for the financial sector to add to their numerous efforts to restore investor confidence. But until the investor trust in the markets is restored it seems there is little that the government can do as at now to ease the crisis. The government has as well sort the help of the globe to fix this situation for the reason the country is also highly dependent on banking flows that cross the county’s borders.
Question marks and eye brows have been raised about the banking systems fiscal policy, regulation and general governance and their ability to guard the system form excessive risk taking. In conclusion recession is a condition that has devastating effects on the economy of any country. Especially in this decade the market forces operate in such a way that it has become very hard for economists to precisely predict any looming crisis to ensure that governments take preventive measures early enough.
Market forces have served to increase the cost of living not only in the country but also globally. Wealth distribution has consequently become uneven with the margin between the rich and the poor becoming even wider. All the governments’ have left is to institute the right regulations and policies that will especially work to enhance the operations of our financial systems and then hope that when the markets recover from this crunch that will be the end of financial crises.