Vol 5 (2008) - Issue 2

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The Credit Crunch: What's the Depth of the Bite?

You would have to have spent most of the last eight months in an igloo to have missed the words 'credit crunch'. The media has been full of news and comment
about it and probably not a day goes by without the subject hitting the front pages of the news, with the Northern Rock story making it particularly dramatic
and visible for the vast majority. Looking at the queues in front of the bank’s branches, you didn't need to hold a PhD in economics to realise that something
really wrong and really serious was happening, and everything that had to do with 'credit' suddenly became tainted with suspicion.

There has been a great deal said about the root causes of the crisis: about the banks attitude to credit risk, the greed of their managers and short-termism of
the markets. But, once the dust settles on the collective hysteria of the first days of the crisis, it's probably useful to analyse its consequences on the real economy and in particular on corporate credit risk in general.

The crisis initially began in the summer of last year with what, at that time, was very much 'only' an interbank crisis; pockets of credit risk – notably related to the American sub prime mortgage markets – were reprised, and certainly they needed correction. When I say 'only', it is not to minimise the extent of what has been in fact a shock of unprecedented magnitude over the world’s financial systems, but to state that – in its initial phase – this crisis had little or no consequence outside the banking industry.

In our position of actively insuring more than EUR 800 billion of business-to-business credit transactions worldwide each year, we were able to take an early view on what was happening. Whilst it was clear that the crisis might indeed have implications for the health of the economy and the corporate sector in the longer run, any such implications would be a secondary consequence of the crunch. Indeed, during most of the second half of last year, in their bid to restore market confidence, all of the banks have made a point of continuing to provide financing facilities to their corporate customers, and, although they were becoming undoubtedly more expensive, there were no obvious refinancing programmes that looked likely to stall.

A self-inflicted wound

Historically, a credit crunch can be typically linked to a central bank or government decision to reduce availability in the market, resulting in a squeeze. The principal difference this time is that the crisis was very much of the bank’s own making – a self-inflicted wound. But what was initially only a financial crisis, is currently turning into an economic crisis.

Obviously, no two 'economic slowdowns' are ever identical. Certainly they stem from the same factors – credit, availability and cost – but what prompts these
issues is never the same. However, what we have learnt in the past that, whether the slowdown is the result of a financial markets crisis, or any number of factors, its impact on the ‘real economy’ and in particular the way it spreads in terms of corporate risk stays predominantly the same.

We are now observing the consequences of an economic slowdown in terms of increased difficulties within the corporate environment that is not in itself untypical. Companies are doing what companies do in such situations when availability is tight. And I believe we are now, after six months of the current crisis, arguably at a tipping point, where reduced liquidity in the banking
sector is filtering into the business community.

The economic indicators

Over 80% of all business-to-business transactions are conducted on credit terms and trade creditors are increasingly being used as a source of finance as banks
tighten their lending. A reduction in bank credit means that businesses begin to extend their supplier terms. This leads to increased risk of payment defaults and ultimately business insolvencies increasing in the coming months. The actual and forecast figures in a recent (December 2007) survey made by Euler Hermes suggest just this pattern of activity. For example, the pace of increase in payment delays from UK customers has returned to a level close to Q1's ive-and-a-half year high – blamed on deteriorating cash flow and greater uncertainty amongst domestic clients.