AbstractThis paper reports on factors that lead into development of credit crunch. Three factors are assessed in order to determine their influence in creating a scenario for decreased lending of financial institutions. First, financial institutions accounting practices are evaluated with respect to factors that predispose credit crunch and strategies that financial institutions impose in order to quench credit crunch from becoming a chronic incidence that may lead to collapse of financial institutions, markets and trading. Potential of marking-to-market of mutual funds and securities, formation of collateralized debt obligations and subprime bonds are evaluated and their potential to future sustainable profits and predisposition of financial crises determined.
Second, structural factors that define conceptual framework are evaluated on the basis of fair value accounting and degree in which financial institutions are aligned to comply with specifications of conceptual framework. Institutional factors that affect sustainability of profit, via efficient financial reporting tools are analyzed as well as weaknesses associated with use of conceptual framework in financial accounting. Third, economic value as a parameter that affects sustained profits and how it positions institutions to deliver value to its stakeholders by working towards profit focused strategies, value proposition and trade offs has been evaluated.
It has been found that poor financial reporting; poor accounting practices and prevalence of operational deficiencies are main factors that easily trigger credit crunch. This means, fair value accounting that is a product of conceptual framework triggers financial crises because credit quality of a financial institution cannot be determined if the financial information is not relevant, reliable, comparable and consistent. In theory, conceptual framework has values that could lead into good financial reporting and accounting practices but its application is limited its weaknesses.
There is therefore a need for revision of the conceptual framework. Introduction Credit Crunch is an immediate financial incident that is characterized by reduced availability of loans from banks that brings about an increase in the cost of securing a bank loan. Banks make the cost of lending money difficult when there is expected future decline on collateral used by the bank to validate issue of a loan. Credit crunch can also result from perceived risk of solvency of other commercial banks in the banking system.
Credit crunch can also be triggered by changes in the monetary markets that force central banks to increase interest rates or reserve requirement. Changes in interest rates of central banks can also occur as a result of central governments having direct control or issuing instructions for banks not to engage in monetary lending activitiesBackground of credit crunchAccording to Dewey (1938) credit crunch arises as a result of sustained inappropriate monetary lending that consequently leads into losses and increase of serviceable debts. The lending institutions increase conditions for credits by setting higher interest rates and thereby increasing cost of accessing credit facilities.
Dewey (1938) argues that monetary losses can make institution to stop further loan advance to institutions. Kaplan and Norton (1996) suggests that in the event of credit crunch the lending institutions re-strategize and re-position themselves and go to liquidation especially if capital for the continued sustainability of business is not enough to see the institution through the credit life cycle. This stimulates inflation and can predispose collapse of the financial institution if there are no measures in place to rescue it to financial economic activity