Credit crunch explained

This was a post I made in my MBA discussions relating to stakeholders for Accounting and Financial Management...

I was working for one of the biggest banks in Australia at the time of the credit crunch. Although Australian banks were not severely affected by the credit crisis (as a matter of fact, they were heralded as being amongst the safest banks in the world), it was still a big deal and my team in Group Risk spent a lot of time doing case studies and discussions to understand the cause of the crisis and the lessons that can be learnt.

The credit crisis was well documented and, in my view, can be broadly summed up as follows. Credit was cheap and abundant all over the world. With so much money, banks started offering it to poor quality (risky) borrowers. At the same time, advancements in technology and quantitative techniques led to an explosion of exotic and complex financial products being issued by investment banks (eg, collateralised debt obligations). The complexity of these instruments and the lack of understanding of the quantitative models used to value these instruments allowed the investment banks to package the high risk loans into a range of products with a variety of risk ratings. Because of the poor understanding of the underlying risks by all those involved (including the regulators and rating agencies), the risk ratings given to these complex financial instruments were incorrect. As the risky borrowers started to default, holders of these financial instruments (which includes banks, governments, etc) started to lose money. The significance of the poor risk ratings is that people who thought they invested in instruments with next to no risk all of a sudden started losing money. Given the interconnectedness of the modern day global financial system, the losses started to flow through all over the world. As losses started to accumulate, having enough money for the day to day running of businesses became all the more important (this lack of funds available for day to day use is known as the liquidity crisis) and so banks, who themselves also need to conserve what little money they had, became more selective in who they lent to (this lack of funds available to be borrowed is known as the credit crisis or credit crunch). With a lack of funds available to be borrowed, companies started to run out of money for the day to day operations of their business (including servicing loan repayments). As a result, many ended up going into bankruptcy.

In this context, there are many culprits – banks for being too reckless, regulators for not doing a good enough job regulating the banks, rating agencies for assigning incorrect risk ratings, and investors for placing too much reliance on the regulators and rating agencies to do a good job (as they say, you should always understand the risks that you are taking before you invest).

Although Australia was not that severely hit by all this, it did bring about some interesting changes. Banks saw the risk with relying too much on wholesale funding (borrowing from other banks around the world to fund the loans that they make in Australia) and so placed more emphasis on funding their balance sheets with deposits (this lead to a price war among banks in the form of more competitive interest rates and reduced fees). It also lead to the demise of several poor performing organisations, whose problems surfaced as credit ran dry.