Climbing out of the Credit Crunch

Root Causes of the Credit Crunch

Key factors

We believe that excessive short–termism, coupled with a lack of accountability both within financial institutions and between management and shareholders, is at the heart of the problem. This has meant:

• failure of institutions to appreciate and manage the inter–connection between the risks inherent in their business activities and management and remuneration incentives
• remuneration structures/bonuses of banks being characterised by excessive short–termism. This neither supports prudent risk management nor works in owners’ long–term interests
• risk management departments in banks which did not have sufficient influence, status or power and
• weaknesses in reporting on risk and financial transactions.

Secondary factors

Further contributory factors were:

• over–complexity of financial products and lack of management understanding of the associated risks — including the fact that, currently, there is no genuine market for certain asset–backed securities
• over–dependence on debt and an assumption of a continuing low cost of capital environment
• scale of issuance of securities and the interconnectedness of financial institutions, especially between retail and investment banking
• human weaknesses: a failure to appreciate the influence of cultural and motivational factors such as rigidity of thinking, lack of desire to change.
• An attitude of ‘it is not my problem’, inappropriate vision/drivers and, perhaps most importantly, human greed
• lack of training to enable management to understand underlying business models, leading to poor managerial supervision
• lack of rigorous challenge by non–executive directors possibly caused by poor understanding of the complexities of the business and
• bad habits and complacency after a prolonged bull market.

© 2008 ACCA