Financial liberalisation

Financial Liberalisation refers to deregulation of domestic financial market and liberalisation of the capital account that implies removing the ceiling on interest rates. When it is in a liberalised system the competition between the different lending institutions for the deposits will increase interest rates on deposits which will increase the deposits. The availability of credit will increase and this will cause an increase in investment growth.

The stages of growth increases activity in the financial markets that makes the introduction and the development of financial institutions. It is argued that financial institutions, by gathering and evaluating information from borrowers, allow the allocation of funds for investment plans to become more efficient and therefore encourage growth and investment.

Banks have a role in the process of development. These banks gives the chance for individuals to hold their savings in the form of deposits, so lowing the need to hold them in the form of illiquid unproductive tangible assets, as this increases liquidity in the economy. Banks could use the deposits to invest such as currency and capital etc. While an individual’s need for liquidity remains unpredictable, banks, by law of large numbers, face a predictable demand for deposit withdrawals, and this in turn allows banks to invest funds more efficiently.

The rate of growth reacts positively to the interest rate but investment reacts negatively to the interest rate. Higher interest rate discourage low return investment, investors will be induced to undertake high return investments, thereby bringing efficiency to investment, which in turn will improve the growth rate to a greater extent than that which is possible under financial repression. Interest rate does not affect of saving indirectly but it is instead a role of income.

The relationship linking the availability of credit and investment growth can be about interest rates which play a role more in particular, lenders and borrowers. The theory is they can be sure about the loans being repaid. The problem is that borrowers can not guarantee their repayments. With this in mind uncertainty enters into the equation in to the loan repayment so lender take measures in case borrowers plans are unsuccessful and lenders try not to lose their loan capital. So in order to cover this they use the credit standard in the loan calculation. For borrowers that mean they will have to be able get the credit standard in order to receive a loan.

If liberalisation happened and the reason was a rise in interest rate this will increase the deposit and increases in the availability of credit. But a rise in deposit will affect the loan rate by increasing but in relation with the size of the loan cause increase in the repayment rate. So credit standard is set on size of the loan and when interest rate increases it does not cover the bank’s loan capital. So if banks would want to be covered by the credit standard they like to have zero credit risk. To achieve this they would increase the credit standard to make sure that they zero credit risk. This will mean that borrower would take a large amount or unable to meet the demand they will not be allowed the loan. This means an increase in the availability of credit will not guarantee access to the loan market.

When interest rates increases, investors who want to get high returns will be attain less than they paid for and they will lose if they sell. Therefore they do not sell.

Investors who invest large amount take advantage of high interest rate; these investors have a high credit risk. So the greater flow of credit makes share prices to increase and they higher profits because of the price increase. Since profit from the acquisition and the sale of shares rises, loan capital will be further attracted to the stock market, so it increases the stock market activity. This introduces the possibility of attracting a substantial portion of the loan capital to move different parts of the economy in favour of financial assets.

This evidently raises a concern about the efficiency gain by means of liberalisation. In this process them return on loans will no longer be linked with the yield from shares; rather it will be inter-locked with the return from the expected change in share prices when economic activities are falling. If bad news spread that will decrease share prices. So investors will not make profit from the change in share prices. Therefore investors will find it hard to keep their debt in order.

This is where a serious problem arises, and that is, if the actual price falls short of the expected price and so borrowers won’t be able to keep their word that they gave to banks. In this problem arises because the banks cannot maintain their credit standard requirements for these borrowers. In other words, banks have advanced loans which exceed the aggregate value of the borrowers’ assets. Thus the core problem lies with banks needing to take high level of credit risk from large loans because of liberalisation.

As said before any bad news that will cause banks a lot of problem and this will lead to a financial crisis. Because of this reason the crisis happens since most of loans had high levels of credit risk.

The credit crunch is what economist use it means a shortage of funds for lending, which reduce the availability of loans. The credit crunch can happen for several reasons because of a shape rise in interest rates and the government has direct money controls and also funds decreasing in the capital markets.

The latest credit crunch happened because of a sudden increase in defaults on subprime mortgages. The Credit crunch started in United States and eventually spread across the world. The mortgage lenders sold lots of mortgages to customers who have low income and who are first time buyers and have not got a good credit rating these customers are the called subprime borrowers. They thought that house market would boom and mortgages still reasonable but they were lax lending of mortgages to subprime borrowers. The reason they were lax is because mortgage brokers got paid to sell mortgages. These cause for more mortgages to be sold, even though it was expensive and high risk of default.

Mortgages companies wanted to make more money on the subprime mortgages and they put the debt into a package and sold it to other companies. This is how it turned globally because of “package sub-prime home loans into mortgage-backed securities known as CDOs (collateralised debt obligations).” [timesonlinea. 24 Feb. 2010]. They sold it to hedge funds and investment banks because they thought they would get high returns on it. They tried to spread the risk but made the situation worst.

The rating agencies gave subprime mortgages a low risk rating but they are very high risk rating and this got transferred to the lenders. In the balance sheets the risk would not be shown.

“Many of these mortgages had an introductory period of 1-2 years of very low interest rates. At the end of this period, interest rates increased.” [mortgagesguideuka, 24 Feb. 2010]. So this cause mortgages repayment to become expensive after the introductory period because interest rate increased from inflation. Also “Homeowners also faced lower disposable income because of rising health care costs, rising petrol prices and rising food prices.” [mortgagesguideukb, 24 Feb. 2010]. Homeowners found it difficult to hold their houses because it was getting repossess.

Many Homeowners were not able to repay the mortgage payments and so this caused an increase in default on their loans. Because of the defaults it was one of the main reasons of the end of housing boom in the US. With housing prices falling this caused further problems with mortgages. “For example, people with 100% mortgages now faced negative equity. It also meant that the loans were no longer secured. If people did default, the bank couldn’t guarantee to recoup the initial loan.” [mortgagesguideukc, 24 Feb. 2010].

Many US mortgages companies went bust because of the increase in defaults but mortgage lender were not only to suffer as banks lost money in mortgage debt because of the package they got from US mortgage companies. Now Banks had to write off big losses and made them unwilling to lend, mostly in the subprime sector.

This was a domino effect and the affect the rest of the world for borrowing money and raising funds. “For example, biotech companies rely on ‘high risk’ investment and are now struggling to get enough funds.” [mortgagesguideukd, 24 Feb. 2010]. Since the borrowing was restricted this also affected the economy with a recession very likely especially in US. But In UK mortgage lender were more controlled in lending than the US. .

In the UK many problems occurred with Northern Rock who invested in subprime mortgages. “Northern rock had a high % of risky loans, but, also had the highest % of loans financed through reselling in the capital markets. When the subprime crisis hit, Northern Rock could no longer raise enough funds in the usual capital market. It was left with a shortfall and eventually had to make the humiliating step to asking the Bank of England for emergency funds. Because the Bank asked for emergency funds, this caused its customers to worry and start to withdraw savings (even though savings weren’t directly affected).” [mortgagesguideuke, 24 Feb. 2010]. Also another banks HBOS having the same situation. This shows that word and mouth can cause total panic in short amount of time.

The events in the US caused the same problems in the UK with mortgages being expensive and the market drying up and with high risk mortgages taken away. This cause house prices to fall and homeowner facing negative equity so they default on loan, which makes bank lose more money. For example “Bradford & Bingley was nationalised because it couldn’t raise enough finance. The B&B had specialised in buy to let loans, which are particularly susceptible to falling house prices.” [mortgagesguideukf, 24 Feb. 2010].

This credit crunch may last for a while because house price in the US as well as UK is still going down which makes mortgage loans under valued. Also interest rates are soaring especially when the homeowner finish their inductor periods. If a recession happens in US it could make more bad loans. It will be hard to get more confidence in the financial markets.

In conclusion credit crunch could have been avoided if banks had a tighter restriction on access to loans, especially in the US and making sure no bad news circulates as this make people panic and making the situation worst. As for financial liberalisation it is important to introduce an interest rate ceiling on deposit rates to reduce excessive competition among lending institutions for depositors, which may minimize the possibility of financial crisis.

Bibliography

Books

Lecture notes

Basu.S. Financial Liberalisation and Intervention: A New Analysis of Credit Rationing

Peter Howells and Keith Bain. (2008) The Economics of Money, Banking and finance A European text Fourth edition, Essex, Pearson limited

Web Page

E. Murat Ucer. Notes on Financial Liberalization, [online] Available from: http://www.econ.chula.ac.th/about/member/sothitorn/liberalization_1.pdf [Accessed 24 Feb 2010]

David Budworth, The credit crunch explained, [online] Available from:http://www.timesonline.co.uk/tol/money/reader_guides/article4530072.ece [Accessed 24 Feb 2010]

Credit crunch explained, [online] Available http://www.mortgageguideuk.co.uk/blog/debt/credit-crunch-explained/ [Accessed 24 Feb 2010]

John Abbey, The credit crunch explained, [online] Available http://www.johnabbey.co.uk/wsb4919660101/creditcrunch.html [Accessed 24 Feb 2010]