In this report I am going to talk about the interdependent global banking industry and what approach should banks take in order to prevent credit crunch. Also, I will explain what lessons were learnt from previous credit crunch that occurred in 2007 and how it affected legal, economic and ethical aspects.
The credit crunch is a sudden severe drop in the availability of money or credit from banks or other lenders.
The banking crisis (also known as credit crunch) in 2007-2009 happened because of a few reasons. First of all banks were creating too much money, in other words every time bank was making a loan it was creating money. In just 7 years before banking crisis the amount of money that banks made became twice as much just by giving loans. They used that money to increase property prices by investing into commercial real estate, and only 8% was invested in business outside financial sector. At some point credit became unplayable, because credit rate was raising much faster than incomes. Therefore, people could not manage payments anymore and they stopped repaying their loans and then banks were in the dangerous situation of being bankrupt. This had big negative impact on whole economy, which led to reduction in amount of lending from banks.
Even though the crisis started in the US, it had a global impact because the financial systems were interconnected. In this case, globalization was negative, because money and loans were easily transferred from one country to another, US crisis started chain reaction which later on affected many other countries.
One of the main economic impacts is the rise of inflation, UK inflation raised by 1.3% only in one year (2007-2008).
What can be done to prevent financial crisis in the future? Fist of all, to regulate how banks lend out money, to crack down on extortionate loans as well as propose stricter regulations on how banks get their money in the first place.
Basically, credit policy must be changed, so if a loan is provided to get a house it should be segmented, for example: price of the house is 100 000$ maximum amount of loan can be 60 000$ and the rest client must pay himself which will benefit to client because he will need to return less and bank will be in safe situation because they know that client will be able to pay loan back, as it is not more then the cost of their property.
Banks approach to allocation of their reserves should be changed and diversification into different expenses should be applied. Therefore banks should reduce the amount of loans given out for property and start providing more loans for other needs such as business start-ups, education and company developments. Banks need to be more careful in choosing potential clients, by making sure that he has enough stable income to re-pay their loan.
Apart from credit regulations social security packages should be implemented, this will protect both clients and banks from unpredictable occurrences (illness, job loss).
In terms of legal regulations there should be restrictions applied on bonuses that banks pay to their executive staff. Which means that bankers can only receive some of their bonuses in cash immediately this will be a lesson to bankers as they played a huge role in crisis by giving loans to almost everyone. Bonuses are their motivation so if they were cut back, bankers will be more careful and selective. Also, bonuses should only be paid when final result is achieved, this will provide better motivation for bank workers.
All banks should be encouraged to improve their credit portfolio and manage it correctly, which represents an outstanding balance on a specific date on all issued loans by the bank to both individuals and legal entities.
This portfolio must be managed, which means there should be a series of investments based upon credit relationships and managing the risks involved in these investments. This portfolio will gain its value from the interest of issued loans but it is delicate to credit default. Therefore management of credit portfolio includes risks with potential loans as well as analysis of the total risks portfolio incurs as a whole. Proper management of credit portfolio will put banks in saver environment to operate in. Forming a credit portfolio management department will make this process easier end more efficient for banks as well as will create some working spaces which is beneficial for the governments.
Governments should make sure that all banks implemented credit portfolio management and maybe apply a restriction limit on the amount of loans given out for property so the situation occurred 8 years ago would not happen again.
Some of the banks, which are poorly managed and operated should either be taken over by bigger and more successful banks or deleted from the market. Because, banks make profit from giving out loans small banks will not survive after restrictions applied. The government should redeem bad assets. Or, there should be stricter control from the government on banks operation.
Another action that should be taken by central bank (Bank of England) reserves must be extended by regulations, so there always will be reserve funds in the bank. It can be done by implementing simple rule, for every pound given in the loan 10p must be reserved. Reserved funds will work as safety “airbag” for the bank and whole economy.
In terms of ethics not much can be done in this situation because finance and ethics are not typical bedfellows. However, in some countries certain changes still can be made. For example, in Russia many people cannot afford to buy a house and rental market is developed very poorly, therefore people have to get a loan to buy a house. Development of rental market and providing more property to rent will help many people who cannot buy property somewhere to live.
Another ethical point is to provide people with knowledge of how to operate their finances, many people do not have enough information before taking a loan and then struggle to repay it. If government will provide to citizens more information about how finances can be managed inside family less people will struggle with their money. This will lead to solving economy problems at much bigger scale.
To conclude, Bank of England already made a few big steps in order to maintain financial stability. They supervise financial market infrastructure and collaborate with other UK financial authorities to support financial sector, operational resilience and business community, which gives benefits and safer environment to the whole country. By doing those changes inside banking system The Bank of England plays vital role in maintaining financial stability.
Government should apply restrictions on bonuses and encourage banks to improve their credit portfolio as well as implement regulations for making reserves from loans given out. People should be provided with sufficient knowledge about finances so they can successfully manage it themselves.
Banks should change their policies on loans and provide them for different things and not just properties. Also, banks must be more careful when choosing potential clients and making sure that they will be able to repay their loan by checking on their income and offering insurance (for cases like illness or sudden job loss, or an other situation in which client will not be able to repay his loan).
Overall, general increase of responsibility must happen in banks, government and people.
By taking all steps and making all changes written above any country is very likely to successfully avoid financial crisis or at least overcome it will fewest consequences.