This chapter is a review of literature as presented by various authors and scholars pertaining to the objectives of the study. The literature review provides detailed explanation of theoretical issues surrounding the problem being studied as well as what research has already been done and how the findings link to the problem at hand. The chapter discusses the theoretical literature review and empirical review on the determinants of commercial banks’ lending behaviour (measured by the volume of loans and advances).
2.1 Selected theories related to bank lending.
2.1.1 Credit Market clearing (neo-classical) theory
This theory postulates that if collateral and other pertinent restrictions (covenants) to borrowing remain constant, then it is only the lending rate that determines the amount of credit that is dispensed by the banking sector. Therefore when credit demand increases with fixed credit supply of credit, interest rates will have to rise and vice versa. According to Ewert et al (2000), it is thus believed that the higher the failure risks of the borrower, the higher the interest rate premium.
2.1.2 Loan pricing theory.
This theory explains why it is not prudent for banks to set very high interest rates to optimise profits from investment in loans and advances. If banks set very high interest rates, they could induce the problem of adverse selection and moral hazard by attracting borrowers with very risky projects into the portfolio. These high interest rates act as an incentive for the risky borrowers to consider more risk to their investment portfolio due to high affinity for high returns (Karumba and Wafula, 2012). Sliglitz and Weiss (1981) supported the theory saying banks should consider the problems of adverse selection...
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...to pay off debt at hand, a speculative euphoria arises, and soon thereafter debts exceed what borrowers can pay from their incoming revenues, which in turn produces financial crisis. As a result of speculative borrowing evolution, banks and lenders tighten credit availability, even to companies that can afford loans and the economy subsequently slows down. 2.1.14 Loanable funds theory
Under this theory of interest, interest rate is calculated on the basis of demand and supply of loanable funds present in the capital market. The determination of interest rates in the case of the loanable funds theory of interest depends on the availability of loan amounts. According to Bibow (2000), the availability of such loan amounts is based on the factors like increase in deposits, the amount of savings made and opportunities for the formation of fresh capitals to mention a few.
The financial crisis of 2007–2008 is considered by many economists the worst financial crisis since the Great Depression of the 1930s. This crisis resulted in the threat of total collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. The crisis led to a series of events including: the 2008–2012 global recessions and the European sovereign-debt crisis. The reasons of this financial crisis are argued by economists. The performance of the Federal Reserve becomes a focal point in this argument.
Through the use of statistics, expert testimony, appeals to emotions, and a few comparisons, Scurlock tries to convey his message saying that because the lending industry’s main concern is maximizing profits, they have made it impossible to not have a credit card and avoid being taken advantage of. He accomplishes his goal of clearly relaying his argument to the audience with the high amount of credible support he provides.
... a loan before the loan is given to the person. Banks need to make sound investments as well. Chances are, the banks are using other people's money to invest in things. Banks should not be allowed to do just anything with money that is not theirs.
This, therefore, is ultimately my solution: Since Americans are ruled more by their appetites more than by reason, and since I doubt that our politicians, because of their love of money, can be trusted to act solely in the interest of the citizens who put them in office, there must be legislation dictating that lenders lend at their own risk.
In conclusion, this assignment is very educative. One of the key things learned from this assignment is that no matter how one is willing to take a risk, there is always a limit beyond which he cannot go. Banks should never lend to the subprime beyond the threshold provided by the law. This is irrespective of impeding profits from such an offer. Before getting into a contract, it is always important to understand the terms and conditions. This is because moral hazard does not apply everywhere.
It can be argued that the economic hardships of the great recession began when interest rates were lowered by the Federal Reserve. This caused a bubble in the housing market. Housing prices plummeted, home prices plummeted, then thousands of borrowers could no longer afford to pay on their loans (Koba, 2011). The bubble forced banks to give out homes loans with unreasonably high risk rates. The response of the banks caused a decline in the amount of houses purchased and “a crisis involving mortgage loans and the financial securities built on them” (McConnell, 2012 p.479). The effect on the economy was catastrophic and caused a “pandemic” of foreclosures that effected tens of thousands home owners across the U.S. (Scaliger, 2013). The debt burden eventually became unsustainable and the U.S. crisis deepened as the long-term effect on bank loans would affect not only the housing market, but also the job market.
Cabral, R. (2013). A perspective on the symptoms and causes of the financial crisis. Journal of Banking & Finance, 37, 103-117
“People also hold money to meet unplanned or unexpected purchase and emergencies which is called precautionary demand” (350). Interest rates affect the amount of money people wish to hold in these funds. “The higher the interest rate, the lower the precautionary money balances become” (350).
The problems that Microcredit programs attempt to solve are the problems of moral hazard, asymmetric information, and adverse selection.
The "subprime crises" was one of the most significant financial events since the Great Depression and definitely left a mark upon the country as we remain upon a steady path towards recovering fully. The financial crisis of 2008, became a defining moment within the infrastructure of the US financial system and its need for restructuring. One of the main moments that alerted the global economy of our declining state was the bankruptcy of Lehman Brothers on Sunday, September 14, 2008 and after this the economy began spreading as companies and individuals were struggling to find a way around this crisis. (Murphy, 2008) The US banking sector was first hit with a crisis amongst liquidity and declining world stock markets as well. The subprime mortgage crisis was characterized by a decrease within the housing market due to excessive individuals and corporate debt along with risky lending and borrowing practices. Over time, the market apparently began displaying more weaknesses as the global financial system was being affected. With this being said, this brings into question about who is actually to assume blame for this financial fiasco. It is extremely hard to just assign blame to one individual party as there were many different factors at work here. This paper will analyze how the stakeholders created a financial disaster and did nothing to prevent it as the credit rating agencies created an amount of turmoil due to their unethical decisions and costly mistakes.
If financial markets are instable, it will lead to sharp contraction of economic activity. For example, in this most recent financial crisis, a deterioration in financial institutions’ balance sheets, along with asset price decline and interest rate hikes increased market uncertainty thus, worsening what is called ‘adverse selection and moral hazard’. This is a serious dilemma created before business transactions occur which information is misleading and promotes doing business with the ‘most undesirable’ clients by a financial institution. In turn, these ‘most undesirable’ clients later engage in undesirable behavior. All of this leads to a decline in economic activity, more adverse selection and moral hazards, a banking crisis and further declining in economic activity. Ultimately, the banking crisis came and unanticipated price level increases and even further declines in economic activity.
Many of the “Elite” financial figures could not give a definite answer about why this crisis occurred as well as stated by many of the people interviewed, “We don’t know how it happened.” Many young brokers working for JP Morgan back in the middle of the 90’s believed they could come up with a way to cut risk, credit derivatives. Credit Derivatives are just a way of using other methods to separate and transfer risk to someone else other than the vender and free up capital. They tested their experiment with Exxon Mobile who were facing millions of dollars in damage for the Valdez Oil Spill back in 1989 by extending their line of credit. This also gave birth to credit default swaps (CDS) which a company wants to borrow money from someone who will buy their bond and pay the buyer back with interest over time. Once the JP Morgan and Exxon Mobile credit default swap happened, others followed in their path and the CDS began booming throughout the 90’s. The issue was that many banks in...
The interest rates to a large extent, determine whether to hold cash in hand or deposit the cash in interest paying deposits, such as checking accounts, savings accounts, money market, or
Warwick J. McKibbin, and Andrew Stoeckel. “The Global Financial Crisis: Causes and Consequences.” Lowy Institute for International Policy 2.09 (2009): 1. PDF file.
Bank profitability has always attracted the interest of academics, economists, and policymakers. With increasing regulation during the global financial crisis, however is gives an understanding of what drives bank profits is increasingly crucial. Literature that has examined bank profitability in many countries in the l...