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Thursday, 9 October 2008

Explaining the financial crisis

Goh Eng Yeow explains why the credit crunch is out of control.
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IT IS not surprising to find that many people in Singapore still fail to understand the nature of the grave financial crisis confronting the US and Europe.

Take this email which I had received from a reader after writing a column lamenting that the lack of strong leadership to tackle the global credit crunch crisis.

I had mentioned that taking a personal loan is still a breeze for many of us.

But the reader felt that I was implying that banks here are lending to people without carefully checking their credit ratings.

For one thing, it betrayed a lack of understanding on the checks and balances placed on the local banking system.

Here is my reply: If you have a steady income and pay your bills on time like the rest of us, any bank here should be happy to extend a loan to you if you should need it. This is their bread and butter business.

There are ways to check if you are creditworthy. You have to furnish your pay-slip. The credit bureau, which tracks your credit card payments and your record in paying up any other loan commitments, has to give you a clean bill of health.

If you fail to pass any of these criteria, it is imprudent to lend you even a cent.

Therein lies the roots of the massive crisis facing the US banking system. There was massive fraudulent lending to people with doubtful credit records. The checks and balances on creditworthiness was completely absent.

The lack of accountability was also appalling. The US bank, which extended the loan, did not keep it on its books. Instead, it sold off the loan to an investment bank on Wall Street which then offloaded it as a high-quality bond to other financial institutions around the world. That was how the rest of the world became ensnared in what was a primarily US banking problem.

The problem has grown so bad that that investors have lost confidence in all sorts of financial institutions in United States and Europe - whether it is a big commercial bank, a huge insurer or a Wall Street investment bank.

In particular, the collapse of US investment bank Lehman Brothers had sent a massive shock wave across global financial markets. It was supposed to be solid and deemed to be too big to fail. After Lehman's death, banks in the US and Europe are so scared of making another bad loan that they have stopped lending altogether. They would rather sit on their cash.

This has started to hit ordinary folk in the United States in a big way. Even creditworthy borrowers - those who passed the criteria I mentioned just now - have problems getting loans. If even triple-A rated General Electric, the world's largest conglomerate, experiences hiccups with its short-term fundings, you know that there is a serious credit crunch problem.

If this continues to snowball, there will be serious repercussions.

In a worst case scenario, there will be another economic depression: Companies fold up because they can't get a loan to pay creditors, while waiting for their own debtors to pay up. That will throw people out of work. They start spending less because they have no jobs and they can't go to a bank to get a loan to tide over their cashflow problems. In turn, that sprawls further company failures as consumption crashes.

So what are Western governments doing about it?

In the US, the Fed is getting into direct lending itself. It is paying US banks an interest for parking their money there, and recycling them as loans to cash-strapped corporate borrowers.

The British government has decided to go one step further. It is offering 50 billion pounds to shore up the capital bases of British banks and another 200 billion pounds in guarantees on their loans.

In a nutshell, it is telling banks: Go out and lend. We will guarantee that you get your money back. And its message to jittery investors: We are putting taxpayers' money on the line investing in the banks. We are in all these together and we will make sure they don't lend foolishly.

Will it work ? It may, but it will take time for confidence to come back.

Before I end this entry, let me share some thoughts on why some banks are so badly-hit by the massive financial panic.

Take UK banks. On average, they lend out $1.50 for every $1 in deposit they collect. But they only put up about six cents in capital to back each dollar of loan, in case some of them turn bad and it does happen occasionally.

By contrast, Singapore banks lend out only 80 cents or 90 cents for every $1 they collect from depositors. They are also required to put between 12 cents and 14 cents in capital for every $1 of loan.

I'll leave you to draw your own conclusions from the comparison.

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