CREDIT CRUNCH IN THE UNITED KINGDOM

INTRODUCTION

The credit crunch was defined by MLC market watch as follows “When
banks drastically reduce their lending to each other and others because they
are unsure about how much money they have and whether the borrower can
pay it back. This leads to more expensive loans and mortgages”. The credit
crunch has a long history dating back 1797 when Bank of England entered
the United States of America, back home Britain faced a daunting task as it
had war with the France which created the first known and documented
recession of the previous era (www.recession.org). The crunch lasted for a
period of three years at that time. Bernake and Lown (1991) define credit
crunch as a significant leftward shift in the supply curve for bank loans,
holding constant both the safe real interest rate and the quality of potential
borrowers.

In the last decade United Kingdom can be categorised into four

different sub-periods:

(i) interwar period;

(ii) world war II – 1973;
(iii) 1973 – 1995;
(iv) 1995 – 2010.

During the above phases there have been recessions and corresponding
growth periods which can be seen from the below graph.

Source:http://www.finfacts.com/artman/uploads/3/UK-recession-
2010_jan142010.jpg
 As can be seen from the above charts there has been some major
credit crunches the United Kingdom economy has undergone during this
periods. And the recovery has taken a lot of time at an average of over two
years for the recovery to take full effect. The major events during these
turbulent times have been due to varied factors starting with the great
depression and at this point of time recovering from the credit crunch caused
by the sub-prime mortgage crisis which originated in the United States of
America. Let us now understand the relevant factors which led to this crunch
and then follow up with the measures undertaken by the government to pull
out the economy from credit crunch the nation faced and their effectiveness.

The major factors which created this credit crunch are as follows:

(i) Financial services

(ii) Housing market
(iii) Low savings rate
(iv) Declines in bank capital
(v) Bank supervision overreaction
(vi) New credit standards set by bankers
(vii) Regulatory burden

Let us understand them in detail:

Financial Services

The current recession is hitting the hardest and it has affected all the
sectors like car industry, retail sector; however the finance sector was the
hardest hit in the current recession. Financial sector is one of the Britain’s
most important and vital sectors in terms of generating foreign currency
earnings and national output. This sector is one of the key contributors
towards government revenue in terms of income tax and corporation
revenues (Pettinger, 2009). Hedge funds have been said to be at the centre of
this storm as funds were available at very low interest rates and were able to
takeover many firms and run the businesses due to this factor. An example for
the same would be the case of Cadbury’s Schweppes which has been hoping
to sell its drinks business, which included the 7Up and Snapple, to one of the
interested private-equity buyers, but due to the crisis none of them were able
to afford it. The banks on the other hand are offering support to the private
buyers, however, with revised terms which are not so lucrative. This changed
scenario has brought its own problems and the magnification of the same has
resulted in credit crunch in the market place (Foley, 2007).

Housing Market

The traditional way of banking and mortgages worked on the principal

that the bank carried out the activities of valuating the home and also the
credibility of the customer, then the loan was issued as per the credibility of
the customer. And the amount of lending was based on the deposits the
banks were able to pool in from their customers, this has limited the amount of
exposure the banks faced through mortgages. However, in the recent years
banks have moved on to a different concept where they started to sell
mortgage bonds in the market. This had made it much easier to create
additional funds with the banks. But it has led to abuses as banks had large
reserves and they wanted it to be generating revenue for this they have
issued mortgages to varied customers without proper background check or
credibility check being undertaken on the customer. This can be seen from
the below chart as to how much the mortgage market grew in the last decade.

Source: http://news.bbc.co.uk/1/hi/business/7073131.stm

This phenomenal growth has brought along with renewed issue of

proper risk controls which were lax and this is one of the reasons for the crisis
to grow into major credit crunch issue. If the other issue of the growth in the
mortgage bond market is looked into, it will give us a perspective of how big
the market has grown would be understandable.

Source: http://news.bbc.co.uk/1/hi/business/7073131.stm
 One reason for the credit crunch becoming worse was the fact that
banks have lost the faith and have become reluctant to offer fresh credit in the
market place to either lenders or borrowers equally. The banks have been
forced to reject credit cards, and are insisting on bigger deposits for home
customers. The mortgage market has been particularly badly affected, with
individuals finding it very difficult to get non-traditional mortgages, both sub-
prime and “jumbo”.

Low Savings Rate

In a research carried out by Tatiana K & James S(2006) they have

identified numerous factors that have an impact on the current situation faced
by the economy in the United Kingdom, wherein they point out various
differences on the saving culture in different economies. They have an opinion
that various factors contribute towards the saving habit of a nation like
Demography, the welfare state, retirement behaviour, constraints on
borrowing, income distribution over a lifetime, income uncertainty, capital
gains, etc., They have drawn this paper heavily on the research carried out by
Gokhale et al (1996) which is elaborated below clearly shows that the average
saving rate in the United Kingdom is has a comparative disadvantage when it
comes to saving on the income earned. Even though United States of
America has a less saving ratio that is compensated by the fact that the
average retirement age is six years more than the United Kingdom and Italy,
and when Italy and United Kingdom and are compared it was observed that
the Italians were more spend thrifts then United Kingdom due to the fact that
they would not be able to borrow as much loans as the Britain’s usually do.
The capital markets and other relevant economic infrastructure is not well
established in Italy as it is in the United Kingdom.
This clearly shows that the low saving rate policy adopted by the people and
the government’s reluctance to imbibe this attitude in the minds of its people,
coupled with the free availability of funds in the banks has enabled the banks
to lend more to the customers at the time of the boom. And once, the markets
bottomed out the banks have tightened their strings which resulted in this
crisis and the credit crunch as the banks have relied heavily on the repayment
for maintaining their balances which took a hit due to this factor. The residual
factor of all this factors was the credit crunch.

Declines in Bank Capital

Business-cycle effects typically do not cause a credit crunch. However,

the banks have to undertake certain transactions to be able to maintain a
profitable state. To ensure sustainability in the market place these banks
acquire and dispose off assets to maintain the capital to asset ratio. In a credit
crunch phase the banks would be faced with severe restrictions on availability
excess funds over and above the regulatory minimums set forth. This
happens because the banks would have overexposed themselves in the
growth stage and would not enough liquidity to enable them to hold fort in the
times of recession. To overcome this shortage and non availability of credit
the banks would avoid releasing of new lines of credit. This in turn would dry
up the credit availability in the market place. As the businesses would have
suffered due to non availability of funds in the market the businesses would
be non attractive for lending of funds from the banks. And the same would
affect the production in real terms this cycle becomes vicious and then the
credit crunch would become the centre of the cycle of recession (Robert &
Taula, 1993).

Bank Supervision Overreaction

There is mixed reaction among researchers on the topic of bank

management over reacting to credit crunch. There are varied reasons to
support and contradict this theory some of them being:

- The previous loans would be considered toxic and may require

to be written off and this in turn would reduce capital availability.
- Examiners may become more conservative while evaluating a
bank’s condition which would force the bank to have a high capital
asset ratio.
- The very fact of an examiners criticism would be detrimental for
additional fund availability for the banks to offer as loan to borrowers.
- Higher loan documentation and restrictions would in turn
increase the cost of borrowing and may deny borrowers the opportunity
to have funding for starting new ventures or expanding their operations.
- Some institutions which are considered to be in trouble may
have more restrictions and would not be in a condition to open up their
coffers for new borrowers may not be able to do so. As the examiners
or the statutory bodies may impose restrictions on the amount of funds
that can be made available for lending from the institutions which are
considered to be at the bottom of the pyramid in terms of recession
(Robert & Taula, 1993).

New credit standards set by bankers

Atypically severe recession have a devastating effect on both the

borrowers and lenders in this case the corporate and bankers respectively. In
the recession phase the bankers will re-evaluate their credit line and risk-
taking behaviour as they would consider that their risk appetite was too lenient
and would relook at their processes and tighten the controls around the
lending policies. In a recession the bankers would have avoided credit to lot of
genuine borrowers as per the increased standards that were setup after the
recession. In this case the borrowers would start complaining about the non-
availability of credit and this would induce a credit crunch in the market.

At the other end the bankers would avoid credit to maintain their capital
asset ratio. To maintain the confidence on the face of investors the banks
would still continue to accept applications for lending and would avoid
processing the same or reject them on the statement stating that the lending
is considered to be risky. This puts the banks in a quandary as they at one
end would require maintaining the status as healthy even in the condition
where they do not have the necessary funds available with them. Otherwise
the investors would panic and ask for more returns and / or withdraw their
investments and still depleting the precious reserves of the bank (Robert &
Taula, 1993).

Regulatory burden

There are numerous regulations which are implemented after every

credit crunch and there have been numerous small and some credit crunches
in the past decade. All this have led to mammoth increase in the regulations
on the banks and it has been best elaborated by Mr. Goerge A. Schaefer Jr.,
President and CEO of Fifth Third Bank who stated that

“Our biggest concern in the banking industry is the

overregulation. It’s unbelievable the regulations that the bank
has to live with. If one of our people at one of our banking
centres at one of our branches wants to make a car loan to
you, here’s the legislation that they have to be totally familiar
with: the Consumer Credit Protection Act, the Truth in Lending
Act, the Equal Credit Opportunity Act, the Fair Credit and
Charge Card Disclosure Act, the Home Equity Loan Consumer
Protection Act of 1988, the Fair Housing Act, the Real Estate
Settlement Procedures Act, the Flood Insurance Protection
Act, the Fair Credit Billing Act, the Fair Credit Reporting Act,
the Home Mortgage Disclosure Act, the Fair Debt Collection
Practice Act, the Consumer Leasing Act, the Community
Reinvestment Act, the Bank Bribery Act, and the Securities
and Exchange Act....And this isn’t an inclusive listing. It’s
absolute insanity”.

The above statement clearly illustrates the process and regulations

have put the banks in a quandary and not able to provide appropriate services
to the customers (Robert & Taula, 1993).

Let us have an understanding of the measures adopted by United

Kingdom government to counter the credit crunch.

Measures Adopted by the Government of United Kingdom

The government has taken a lot of measures to kick start the recovery
process. Let us have a look at these measures in brief:

- Treasury announced the waiver on stamp duty for a period of one

year to boost the sagging housing market.
- Nationalisation of different insurance providers like Fortis, Northern
Rock.
- Nationalisation of Bradford & Bingley mortgage operations and
selling of the savings accounts to Santander of Spain.
 - Increasing the guarantee on deposits to GBP 50,000 by the
Financial Services Authority (FSA).
- Announcement of rescue package for banks totalling to an amount
of GBP 50 Billion.
- Reducing of interest rates cuts to half a percentage point.
- Reduction in VAT to ease pressure on the general public.
- Support to housing schemes through various measures.

These were some of the measures undertaken by the government to

overcome the credit crunch and ensure availability of resources
(www.news.bbc.co.uk).

Effects of the Measures Undertaken by the Government

Let us see how these measures have helped the economy to recover
from the credit crunch.

The measures adopted by the government have taken some time to

show the effects as the benefits needed to trickle down to the population.
However, as can be seen from all the other recessions the phase of credit
crunch took a little over two years to gain some sort of semblance and exit out
of the falling growth that was witnessed due to the credit crunch. Initially there
was scepticism in the measures being adopted by the government. However,
as all good things it took some time but the recovery is happening in slow and
stagnated phases across the economy in small steps and as mentioned there
are some green shoots which can be observed in the economy and the same
can be attributed to the measures adopted by the government in the near
term.

The measures on housing and decrease in the VAT and reduction of

bank interest rates have boosted the housing sector which is considered to be
a critical sector as it supports a lot of other services and can be seen to be a
sector which has a lot of scope to develop and ensure the growth of other
sectors also. As there is a dependency of lot many sectors which are either
directly or indirectly supported by the housing industry which is very important
in the United Kingdom market. The growth in this sector has revived the
options of a lot of other sources like the supporting industries involved in
furnishing and other activities which would be able to increase their sales
through the creation of new market and segments in the market to support the
newly occupied houses who would require a lot of furniture and other items for
their houses.

The banking sector was given a boost with the slew of support
measures which were announced ensured that the sector would be able to
limp back to normalcy as the government has provided it appropriate support
and funds to bail out this sector. The banks were given option of merger and
bankruptcy support which have enabled them to get over the crisis and be
able to substantially raise their disposable cash availability which was used to
build back the lost ground and create a healthy atmosphere again.
 On the retail front the government has reduced the VAT to boost the
sales and revenue generation to grow as United Kingdom economy has a lot
of dependency on the retail sector the support has ensured that the sector
was able to reap the benefits of this and gain in confidence of the general
population. At the same it enabled the customers to buy more products with
the limited amount of savings they had and ensured that they were able to
spend the amount on quality and necessary products. Hence, the
government’s decision to reduce the VAT has been a positive sign and helped
the economy to limp back in certain ways. However, the recent measure to
hike the VAT again has been seen as a retrograde measure but it needs to be
seen that the government would require certain level of funds to ensure that
they are able to run the machinery and other mechanisms in the country for
which monetary resources are required.

By increasing the minimum safety support to investors in banks to GBP

50000 the government has created an option to the banks to attract more
investments on this basis even at relatively lesser famous banks as the there
exists an advantage in terms of bankers guarantee.

Conclusion

The credit crunch is a phase where the economic activity of a country

is severely affected as a result of the non-availability of credit lines in the
economy. There are many reasons and circumstances under which the
economy would get affected by credit crunch. The major reasons have been
discussed in the above paragraphs. And some of them clearly state the
causes and identify the reasons which are creating this kind of issues as can
be seen from the above factors it can be stated that a credit crunch or slowing
down of economic activity is caused due to the issue of non-availability of
credit and the credit crunch happens due to various factors like the bankers
who would lose trust in the system and create a scenario where they would
not make available the cash flows to run the economic activities and this
would become a vicious cycle which would have an impact on the overall
activity and bring the entire cycle to a standstill.

It can be said that credit crunch is a period when the economy takes a
breather and allows an opportunity for everyone to grasp the growth which
has been taking place or it can be said a course correction exercise that is
taken by the economy to refocus on the current trends. And every economy
would have to go through this phases at different points of time as it is
necessary for the countries to realise the effects of uncontrolled economic
activity and the results of the same to be understood and analysed by the
economists or the political class who are the policy makers. The slow down or
credit crunch is the time when the cooling down happens in the economy and
creates a state of relevance to the activities being undertaken and ensure that
the negative effects or the slack that is created in the system which has been
built up over the years due to the fact of uncontrolled economic activity is
pruned down to manageable levels. This subjective way of looking at things
would provide us with an option of reinvigorating the positive methods and
learn from the negatives which would be used to ensure that the system
carries on with an effective positive and efficient system in place.

It brings along with it lot of unemployment and loss in security,

governments across the globe should refocus their policy decisions to avoid
future pitfalls of this nature. There has to be certain checks and balances
which need to be incorporated or the rate of growth needs to be moderated
and people educated to adopt skills in a growth phase like saving to ensure
that in case of any credit crunch the loss is not felt severely.

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about?
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