Business | Opinion
The current credit crunch was borne out of a crisis in confidence
Some weeks ago I read an amusing article, in which an investment banker at a dinner party in London was taken aback by a vicious attack on his fraternity.
- By Sidarth Menon, Special to Gulf News
- Published: 23:51 December 21, 2008
Some weeks ago I read an amusing article, in which an investment banker at a dinner party in London was taken aback by a vicious attack on his fraternity. Guests at this party were piling on the kind of disgust and anger typically reserved for drug and arms dealers.
In a profound reversal of fortunes, he was left desperately wondering if he would have to invent a phony career purely to survive a social outing. How times had changed. From relishing the idea of adding the word 'Investment' before the much broader 'Banker' title to cowering behind a faux profession.
As a member of this fraternity, I myself have had tough questions thrown at me. Given the mess we are sitting in and the general 'pass the buck' attitude of everyone responsible, frustrations are likely to run riot.
Undoubtedly, it was massive amounts of capital financing US consumers' desire to own homes that got us on the train to Recessionville. Yet ultimately, it was the dreaded 'credit crunch' that really took us home.
Creditors and Debtors have hit a new low in a relationship that's as old as the vaunted institution of marriage. The 'credit crunch' we now experience is borne out of a crisis in confidence, driven by asymmetric information between lenders and borrowers. As the economist Frederic Mishkin wrote, "...borrowers have an informational advantage over lenders because borrowers know more about the investment projects..."
This inherent deficiency in the relationship between creditors and debtors is only exacerbated in the current environment of mutual distrust, very much like a couple locked in a bad marriage. In countering further deterioration in this relationship, central banks have unquestionably taken dramatic and unprecedented action.
One of the only points on which you will find little debate among the analyst community is that without such policymaker activism, our trajectory would look very similar to that of The Great Depression. However, these spectacular efforts have done little to get credit markets working again.
Mr Creditor and Mrs Debtor have been badly scarred by the events of the recent past. They are not willing to look past recent indiscretions and trust each other. Access to cheap capital thus far has translated into banks holding more cash on their books but done little to encourage them to lend again. Capital or the gatekeepers of capital have lost their way in their bid to allocate capital to the highest risk-adjusted return.
Marriage on the rocks
In short, we have a financial system that is broken, a marriage that is on the rocks. But like in a marriage, we need more than just expensive advice from an analyst far removed from the problem.
We will only get back to a functioning financial system once sentiment shifts; and lenders with healthy balance sheets start offering credit to sound borrowers. The two may be scare commodities these days, unlike the various opinions offered to us by pundits, but they are out there. Trust, whether in a marriage or financial market is easily lost but only cautiously regained. The good news is that the first tentative steps at reconciliation seem to be underway, evidenced by the sustained decline USD Libor rates. The bad news is that it will take time, transparency, communication and a whole lot of money to foot the therapy bills.
In the words of Warren Buffet, "It takes 20 years to build a reputation and 5 minutes to ruin it. If you think about that you will do things differently." Perhaps bankers will take this to heart and implement reforms, both institutionally and professionally.
- Sidarth Menon, CFA, is an Investment Manager at Fortis Private Bank
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