The Ostrich Removes its Head From the Ground - The Bank of International Settlements Admits a Second Credit Crunch is Likely

24/07/2012 17:16 BST | Updated 17/09/2012 10:12 BST

The Bank of International Settlements (BIS), which is considered the central bank of central banks, has raised alarms that the world may be in for a second credit crunch. Chief economist Bill White, who is near to finishing his term at the BIS, claimed that, "The current market turmoil is without precedent in the postwar period." I have to admit this is something I have been saying for some time. I also think there is some confusion as to what a credit crunch is and question the actions taken by the central banks, which I think was actually to prevent a bank run and not to deal with a second credit crunch.

A couple of years ago I went to a dinner with some of the top people in finance and in particular banking. I said at the time there would be a second credit crunch and I was tut-tutted and laughed at. I heard a voice say that reserves were much larger now, so a second credit crunch was not possible. Unhinged by the negative response I kept my mouth shut but thought to myself, "What do bank reserves have to do with credit crunches?" You see a credit crunch occurs when credit products, such as credit and default derivatives, are not purchased on the debt market.

There are many problems that arise from a credit crunch. The main one being banks cannot lend as much as they used to because they do not have the demand to sell the debts off to someone else. When you go to a bank to borrow money they will bundle up your debt contract with other borrowers and sell it on the debt market as a Conglomerated Debt Obligation. This is where the credit crunch happens, if investors do not buy those products the market for debt and thus the ability for banks to lend dries up. This means banks have to hold onto more of their debt products themselves, which means they have to increase the interest rate, because the risk rises, or they simply lend less.

The reserves of a bank can be affected by the reduction in income if a credit crunch ensues however a bank run, which is created by a deficiency in reserves is at most a creation of a credit crunch not the other way round. Thus having a high capital ratio (bank withdrawal reserve, the thing the person at the dinner party claimed would prevent a bank run) will do nothing to prevent a second credit crunch. I wrote an article differentiating between the two economic anomalies here. In short the strategy imposed by the central banks would do nothing to prevent a second credit crunch it merely stopped the secondary problem of a bank run. Although this action prevented some banks from failing it did not secure the future of the lending market.

The only action taken by governments and central banks that could have resolved the problem of a second credit crunch was the increased cheap lending they gave to banks through the low interest rate, which was achieved by Quantitative Easing. So far most banks have not lent out as much as they were expected to because they have been building their reserves to prevent a future bank run, which is likely due to the high levels of bad debt they anticipate will diminish their income. So not only has the increased reserve quota not reduced the chances of a second credit crunch it has made it more likely as it has reduced lending.

The other issue preventing lending is the increased risk that has occurred as a result of the economic crisis. The higher the risk the less money is lent and the higher the interest rate for the few borrowers who are lucky enough to get credit. I wrote an article about this recently at the Adam Smith Institute, which you can read here. In short the higher risk seen in the economy, which has been created through the credit problems, has made banks become more cautious about how they lend money to businesses and who they lend it to.

It is about time the BIS admitted it is likely there will be a second credit crunch. I think people need some honesty in the economic crisis. I anticipate it will become much harder to get credit for small businesses over the next few years and that there will be less opportunity to enter the market place as a result. Countries with high public and private sector debt will see the biggest impact in terms of a reduction in lending as the macroeconomic conditions a high level of leverage creates are unattractive to investors.

The consequences of a reduction in lending will likely lead to a fall in demand in the property market as well as business collapse. As the ability to get a mortgage will deteriorate the property prices seen in recent years will decline rapidly creating a 'dirty market correction'. This will make housing more affordable for some but put many people into negative equity, as the price they paid for the house and the outstanding mortgage will exceed the equity value and current price of the property.

We are currently at a crossroads in the economic world. There are two options, either let the economy correct itself and lose billions in property values and business failures. Or continue to stimulate the economy through Quantitative Easing. Both of these options have terrible outcomes. Market correction will lead to economic hardship and repossessions of property on perhaps an unrivalled level in history. Further QE will lead to a devaluing of the currency on the international market and will probably create a transfer in wealth. I am just glad that the BIS is making an honest statement for once and allowing people to become aware of the situation so they can plan for the future, instead of allowing them to believe things will continue the way they have.