Dada Adefolami

By Dada Adefolami

What is the term Financial Crisis?

The term financial crisis is applied broadly to a variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics.

A financial crisis is a situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often associated with a panic or a run on the banks, in which investors sell off assets or withdraw money from savings accounts with the expectation that the value of those assets will drop if they remain at a financial institution.

A financial crisis can occur as a result of institutions or assets being overvalued, and it can be exacerbated by investor behavior. A rapid string of selloffs can further result in lower asset prices or more savings withdrawals. If left unchecked, the crisis can cause the economy to go into a recession or depression.

International financial crisis
When a country that maintains a fixed exchange rate is suddenly forced to devalue its currency due to accruing an unsustainable current account deficit, this is called a currency crisis or balance of payments crisis. When a country fails to pay back its sovereign debt, this is called a sovereign default. While devaluation and default could both be voluntary decisions of the government, they are often perceived to be the involuntary results of a change in investor sentiment that leads to a sudden stop in capital inflows or a sudden increase in capital flight.

Several currencies that formed part of the European Exchange Rate Mechanism suffered crises in 1992–93 and were forced to devalue or withdraw from the mechanism. Another round of currency crises took place in Asia in 1997–98. Many Latin American countries defaulted on their debt in the early 1980s. The 1998 Russian financial crisis resulted in a devaluation of the ruble and default on Russian government bonds.

Explanations range from the simplistic (‘it’s all the fault of greediness), most would agree on the following factors:

1. Low interest rates led to people borrowing more money than they could afford since property was ‘certain’ to increase in value.
2. A continuing upward trend in property values led to more properties being purchased as investments.
3. With the value of property ‘guaranteed’ to rise, banks relaxed their lending requirements.
4. First-time borrowers and low-income families had to borrow higher multiples of income to get onto the property ladder.
5. Home loans became securitized; lenders sold the rights to bundles of home loans as collaterised debt obligations (CDOs) on to other banks/investors, including sub-prime loans made to borrowers with poor credit ratings.
6. People felt wealthy so they spent more, leading to heavy personal debt.

It was all fine, as long as the housing market continued to rise; received wisdom was that if sub-prime borrowers had repayment problems, they or the banks could just sell the properties and realize their gains.

Take example of US In 2007, prices across the US began to fall. Struggling homeowners discovered they couldn’t sell for enough to clear their debts. Banks discovered the foreclosure process was expensive and didn’t realize enough to pay off loans. Borrowers were unable to renegotiate their payment schedules as they didn’t know to whom their debt had been sold.

The bursting of the real estate bubble has led to the following:
1. Banks realizing that their investments in CDOs are overvalued, but they have no idea of their true value since they don’t know the identity of the borrowers or their credit ratings.

2. Banks becoming less able and willing to lend money, as falling asset values mean they need to retain cash to bolster their reserves.

3. Insurance companies that had insured CDOs facing huge losses.
4. Falling house prices leading to fewer construction projects, leading to unemployment in the construction sector, with multiple effects on the wider economy.

5. Falling consumer confidence resulting in fewer purchases, especially of big-ticket items. For those who want to purchase, limited availability of finance makes it difficult.

6. Falling stock markets due to falling confidence especially in banks and investors converting funds to the safe haven of cash.
7. Increasing personal default as individuals who are overly leveraged struggle to pay their mortgages and credit card bills.

Professional guidance
Auditors of banks and other financial institutions will be most affected by the current problems; it will be very difficult to determine the value of many assets held, and they face scrutiny from regulators looking at banks’ capital-adequacy ratios.

But most businesses will be affected to some extent. A reduction in consumer confidence will affect sales, a lack of availability of consumer credit will prevent closure of many deals, and companies will face problems raising money for their working capital and long-term needs.

Many professional bodies and regulators around the world have issued guidance on the implications of the crisis. For example, in January 2008 the UK Auditing Practices Board (APB) issued a bulletin, Audit Issues When Financial Markets are Difficult and Credit Facilities May be Restricted, and the International Auditing and Assurance Standards Board (IAASB) has issued two audit practice alerts – in October 2008 and January 2009. The first was Challenges in Auditing Fair Value Accounting Estimates in the Current Market Environment, followed by Audit Considerations in Respect of Going Concern in the Current Market Environment.

The APB guidance identifies issues that need to be considered throughout the audit process, whereas the IAASB alerts focus on the problems of auditing fair value, especially when markets are illiquid, and going concern. All of the bulletins emphasize that they contain no new guidance – i.e. that existing auditing standards still apply – but that they provide expansion in some areas.