The Main Causes Of The Bad Loan Market Crisis In Recent Years

The Main Causes Of The Bad Loan Market Crisis In Recent Years

The dramatic rise of loan defaults in the world’s largest banks is a matter of concern. The outbreak of Covid-19 has affected everyone out there, be it ordinary people, giant businesses, or social safety net systems, and paved its way to another financial crisis. 

A majority of well-known financial institutions in the United States, such as JPMorgan Chase, Bank of America, and Wells Fargo, are warned by the world’s prominent banking institutions as they may not fulfill their loan obligations, giving rise to the dire loan market crises. 

According to the Federal Reserve Bank of NY, it is expected that American households held $14 trillion in debt, including more than $1.3 trillion in auto loans and over $900 billion in credit card debt, at the end of last year. 

While low global interest rates may have contributed to the boom in housing markets and speculative excesses, the microeconomic distortions and poorly understood financial system innovations played a more fundamental role in creating this havoc. 

Although banks are in way better conditions than the 2008-09 financial crises, the impact of delay payments and loan defaults can be severe and might impair even the most balanced sheets. It’s still unclear how and when the US market will regain economic momentum, as conditions worsen after detecting the Omicron variant in US citizens. 

Over the past several years, US policymakers and economists have been very active in offering policy advice to other countries about avoiding and managing financial crises. But it’s a matter of huge surprise the country itself is standing on the edge of a bad loan crisis after the outbreak of the Covid pandemic. 

An Overview Of The Major Causes of Bad Loan Market Crisis

The precise causes of the bad loan market crisis remain surprisingly controversial. Much of the recent analysis has blamed the pandemic and the role of developments within the US housing and financial markets for this economic recession. 

It is essential to understand the root causes of this terrible situation to overcome the ongoing loan defaults.

  • Pandemic and Subsequent Lockdowns

The primary cause of this crisis is none other than the pandemic and its subsequent lockdown measures. It’s no secret that Covid-19 has hit the world economy hard, and the US market is no exception. Although the lockdowns and other safety concerns restrict the spread of the virus, they automatically put American institutions at an alarming risk of loan defaults. On March 19, Credit Suisse warned in a report that the “impact of the pandemic on our financial results is difficult to evaluate, but we are trying to figure out our credit exposures prudently.”

The CEO of Deutsche Bank, Christian Sewing, also discussed with German news publication FAS in an interview the possibility of widespread corporate loan defaults, warning that such a scenario mainly depends on how much and, above all, how long the coronavirus burdens the economy.”

Undeniably, the Covid-19 pandemic and its different variants have halted businesses and other financial institutions, leading to such a crisis. 

  • Dependence on unstable short-term funding

The banks’ dependency on unstable short-term funding has witnessed a gradual rise in recent years, leading to the situation. Both the shadow banking system and the largest banks in the world rely on the various forms of short, wholesale funding, including commercial papers, repurchase agreements, contingent funding commitments, certain types of interbank loans, and more. 

The reliance of shadow banks on short-term uninsured funding made them subject to run, much as commercial banks and thrift institutions. However, it insists financial firms put aside liquidity by moving asset holdings into highly liquid securities.

The supply of highly liquid securities is relatively inelastic in the short run. Additionally, the efforts never increase the financial system’s liquidity as a whole but serve only to raise the price of liquid assets while decreasing the market value of less-liquid assets such as loans. Such liquidity pressures will make firms less willing to extend credit to both financial and nonfinancial firms, leading to a bad loan market crisis. 

Central Banks also warned that the risk of temporary liquidity crunches always remains as the economic shutdown rolls on.

  • Loopholes in Risk Management Paradigms

Although the vulnerabilities associated with a pandemic or short-term funding can be seen as a structural weakness of the global banking system, we cannot neglect that they are a consequence of the poor risk management system. 

From the significant collapse of mortgage underwriting standards to a weakening of underwriting standards for commercial real estate loans to excessive reliance on credit ratings to insufficient capacity by many large firms to track firm-wide risk exposures, everything is showcasing the defect in the risk management and control system. 

  • Leverage

Excessive leverage is often a significant cause contributing to the bad loan market crisis. Unarguably, several households, businesses, and financial firms took more debt from banks than they could handle or repay on time, leading to credit downgrades and defaults. 

However, the worst part is that assessing trends in leverage for financial firms is not straightforward because available statistics are inadequate. Also, leverage can be very difficult to measure in a world of complex financial instruments. 

Moreover, this cause tends to be pro-cyclical, rising in good times, when the trust between lenders and borrowers is high, and falling in bad times, when trust turns to caution. It, in turn, increases financial and economic stress in the downturn and leads to debt defaults.

Debt defaults also leads to an increase in unsecured and high risk loans. With lower credit scores, householders opt for a lot of payday loans and other such unsecured loans to tide over the financial crisis. 

Central banks worldwide are taking appropriate measures to safeguard international financial institutions to keep credit flowing as economies are deeply affected by the pandemic. They do so by maintaining low-interest rates and extending lifelines to highly-impacted businesses and lenders. A team of analysts at the BlackRock Investment Institute penned down a research note claiming that such monetary policy measures will reduce downside risks to the economy and the growing threat of an oversized spike in debt and credit defaults.

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