credit crunch and banks' margin

Topics: Debt, Bond, Bank Pages: 8 (1837 words) Published: October 15, 2014
Questions
1.     Does offering covered bonds hold the answer to credit rationing (credit crunch) in a financial crisis or does it just offer banks the opportunity to increase their margin? Discuss critically. (25%) In 2008, due to the global financial crisis took place in America, which made a bad influence all over the world in term of the financial market, banks decided to improve lending standards by providing higher interest rate than the market interest rate conditions for loans, which leads to decline in credit growth. By this way, credit funds are difficult to meet the reasonable needs of social reproduction.

This phenomenon is credit crunch (also known as a credit squeeze or credit crisis), Credit Crunch also known commonly as liquidity rationing, which means a reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from the banks. Therefore it is independent of interest rate movements. However the disadvantage of this is to change the relationship between credit and interest rates so that credit becomes less available at a given interest rate level or there ceases to be a clear relationship between credit availability and interest rates. The reason why these events of a liquidity rationing often happen is the result of reckless lending management, which leads to bad debt for institutions. Consequently, when the investors cannot reimburse their loan payments, banks are forced to take sudden action and tighten the availability of loans or credit. For example, the Financial Crisis is a prime example of a credit crunch that resulted in a near collapse of the global financial markets.

Covered bonds are debt securities backed by cash flows from mortgages or public sector loans. Compared with asset-backed securities created in securitization, the main difference is that covered bond assets remain on the issuer’s consolidated balance sheet. One important enhancement of covered bonds is to recourse a pool of assets that secures or "covers" the bond if the originator (usually a financial institution) becomes insolvent and bankrupt. So for the investor, one major advantage to a covered bond is that the underlying asset pool remains on the issuer's financials, and issuers must ensure that the pool consistently backs the covered bond. In case of the event of default, the investor has recourse to both the pool and the issuer. Apart from what l mentioned before, based on asset’s remaining on the balance sheet covers the bond, covered bonds are essentially risk free when being invested. And this advantage has made covered bonds become one of the most successful and popular investment instruments since their creation in Denmark back in 1795. But the covered bond market was not totally immune to the effects of the crisis. One of the serious problems is that institutions cannot always accurately evaluate the assets. Past events like the GFC have shown assets being falsely rated. Up to the intensification of the crisis following the collapse of Lehman Brothers in mid-September 2008, it was a clear example to illustrate that the covered bond market had outperformed other wholesale funding instruments.

The function of a covered bonds market is highly important to ensure the stability of financial market by providing a useful and constant funding source for mortgage lending. For example, in term of financial crisis the risk appetite of investors shifted towards less risky assets. At the end of 2008 in European, as the crisis progressed, which resulted liquidity continued to worsen, the European Central Bank’s made a decision to support covered bond market by taking measures under the Covered Bond Purchase Programme by purchasing bonds through European Central Bank. The picture blow shows obviously the increase in covered bonds as opposed to unsecured and government-guaranteed bonds during the global financial crisis.

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