Financial Crisis Glossary – a guide to the buzzwords of the crisis
November 1, 2008
Every day there's a new word entering the lexicon--some of it well established terminology from accounting and economics, some of it the creative buzz of a crisis, and the rest just plain jargon. Here we take a look at some of the most common terms affecting microfinance.
Credit Crisis or Credit Crunch
A credit crisis, or credit crunch, is a sudden reduction in the general availability of loans (or credit), or a sudden increase in the cost of obtaining loans from banks. As a result of an increased perception of risk, microfinance institutions may find the costs of loans increasing.
In March, the New York Times provided a simple explanation of how the housing crisis rippled out to become a much broader credit crisis.
Counter-cyclical
Counter-cyclical is the term used in economics to describe an element that moves in the opposite direction to the overall economy. In previous financial crises, microfinance has weathered the storms well, faring far better than other banks whose business was more closely tied to mainstream domestic and international markets. Statistical evidence from Adrian Gonzalez published in MicroBanking Bulletin shows that microfinance institutions have proven to be less vulnerable to economic downturns.
This time, with many MFIs more connected to the markets than before, things are likely to be different. Institutions that depend heavily on cross-border borrowing instead of deposits to finance loan portfolios are likely to feel the liquidity squeeze most sharply. Few people are predicting that microfinance will come through unscathed (in contrast, for example, to the Asian financial crisis of 1997). What's clear is that the impact will vary from country to country and that institutions could suffer from a liquidity crisis.
De-coupling
China and the world's other large emerging markets were until recently widely considered to be immune to the travails of the economic superpowers, and “decoupled” from their paths. That has changed. As western stock markets have crumbled, stock markets have plunged in emerging economies such as China, South Africa and Brazil, and many currencies have fallen sharply.
Insolvency
Insolvency is inability to pay one’s debts. It is often contrasted with illiquidity, which means having insufficient management team assets to cover short term liabilities. Insolvency means having negative net assets; liabilities exceed assets.
Insolvency is not synonymous with bankruptcy, which is a determination of insolvency made by a court of law.
Leverage
Leverage, or gearing, is borrowing money to reinvest in an attempt to increase the returns to equity. Leverage allows greater potential returns to the investor when cost of borrowing are less than returns on investment. The potential for loss is also greater, because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid. Deleveraging is the action of reducing borrowings.
The Economist calls excessive and excessively pro-cyclical leverage "the chief villain" of the current financial crisis.
Liquidity Crisis
When a business finds there's not enough cash to pay for day-to-day operations, grow the business, or meet debt obligations when they are due, it's suffering a liquidity crisis and may look to an injection of cash to prevent business failure. The decision whether to "trade through" a liquidity crisis or declare bankruptcy depends on whether the business is considered viable.
For this reason, international financial institutions like IFC and others are creating emergency liquidity funds to offer microfinance institutions an immediate stable source of funds.
NINJA Loans
Loans provided to borrowers with no income, no job, no assets, so that the only security is the value of the homes. Such loans were heavily marketed to subprime borrowers in the United States. When housing prices stopped going up or declined, these borrowers’ debt exceeded the value of their home.
Portfolio at Risk (PAR)
Portfolio at Risk (PAR) is a standard international measure of portfolio quality that measures the portion of a portfolio which is deemed at risk because payments are overdue. PAR 30 means the portion of the portfolio whose payments are more than 30 days past due. PAR 30 above 5 or 10% is a sign of trouble in microfinance. High delinquency makes financial sustainable impossible for an institution.
Real Economy
The real economy generally refers to the nonfinancial economy—for example, manufacturing, farming, trade, and services.
Remittances
Remittances are cross-border money transfers, often sent from workers employed abroad back to their families in their country of origin. Remittances are a major source of capital for developing countries, and they have been soaring in recent years, helped by lower money-transfer costs. The economic downturn in developed countries will likely lead to reduced remittances to developing countries.
For example, the Inter-American Development Bank(IDB) projects money transfers will contribute 1.7% less to household incomes in Latin America in 2008 than they did in 2007. The slowdown comes as inflation is rising in most Latin American countries.
Responsible Lending
Responsible lending refers to the lending policies and practices of financial institutions that take steps to ensure that clients are treated fairly, and benefit from the loans they receive. Central to the responsible finance concept is a commitment by the lender to avoid over-indebting clients, by offering well-designed products and carefully establishing ability to repay.
In recent months, the microfinance industry has promulgated Consumer Protection Principles for minimum agreed standards around the treatment of clients. Major investor institutions have signed up to an agreement for six key Client Protection Principles. Other ongoing activities include the work of retail microfinance providers, national associations, the Social Performance Task Force, the "Beyond Codes” Project and Microbanker’s Oath promoted by The Center for Financial Inclusion at ACCION, WOCCU’s International Credit Union Consumer Protection Principles, and CGAP’s Disclosure Guidelines for funds that specialize in microfinance.
Securitization
From mortgages to car loans, to credit cards, to microcredit loans—financial assets can be packaged, pooled, and sold to investors as securities. While securitizations of microfinance related assets are relatively new, in the United State the value of pooled securities overtook the value of outstanding bank loans in 2001. One important motivation for securitization is that it can be a cheaper method of raising capital.
Shadow Banking System
The shadow banking system—money market funds, securities dealers, hedge funds, and the other nonbank financial institutions that have defined “new finance” in the past decade—has been radically altered by this crisis. Collateralized debt obligations (CDOs), collaterized loan obligations (CLOs), and a range of unregulated debt products are likely to be more tightly regulated. The importance of core banking principles—strong customer relationships, solid accounting, effective management, staff incentives and recruitment—have all been reaffirmed.
Subprime loan
A subprime loan is a loan offered at a higher rate of interest for people who do not qualify for prime rate interest rates (the rates charged by banks to their most “creditworthy” borrowers). Often, subprime borrowers are turned away from traditional lenders, because of their low credit ratings or other factors that could suggest that they might default on the loan.
Microfinance loans have shown that poor clients can pay back loans at remarkable rates—on average 98%—in the right conditions.
To add your terms, or comment, contact cgap@worldbank.org
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