Importance of QS in Public Organ is at Ions in the Prevaling Recession

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Contents

1. Introduction ...................................................................................................................... 12. Financial crisis and Economic crisis ............................................................................... 2

2.1. Analysis of current financial crisis ............................................................................. 22.2. The impact of the financial crisis on the construction industry .................................. 4

3. Quantity surveyors competencies.................................................................................... 83.1. The quantity surveyors in public and private sectors ............................................... 11

3.1.1. Private Sector ........................................................................................................... 113.1.2. Public Sector ............................................................................................................ 11

4. The key role of quantity surveyors for public sector organisations .......................... 125. Conclusion ....................................................................................................................... 18References:.............................................................................................................................. 19Bibliography: .......................................................................................................................... 21Appendix 1 .............................................................................................................................. 22

List of Illustrations

Chart1. Number of house buildings: permanent dwellings started and completed.................7

Figure1. Sequence of events in a financial crisis......................................................................3

Table1. Number of house buildings: permanent dwellings started and completed.................6


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Importance of the Quantity Surveyors for public sector organisations

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1. Introduction

The global economy is experiencing the worst crisis since the Great Depression. The

financial crisis spread from the U.S. to Europe and beyond in 2008 and makes tightening

credit markets, crashing stock markets, rising unemployment and falling corporate profits.

The UK as a whole officially entered recession in January 2009. GDP fell in the end of 2008

and is predicted to fall more in 2009, which makes the growing concern over its impact on

the economy. (International construction intelligence, 2009). Since the Second World War, it

is the worst downturn that has been seen because firstly; it is a worldwide crisis and secondly,

has resulted in huge fake debts. (Peston, 2008) Construction as well as most other sectors is

entering a phase of deflation. According to Office of National Statistics (2008), construction

output fell by 1.1% in the fourth quarter of 2008 in the UK and thus it is expected that a

massive number of jobs will be lost in next two years. However, the industry needs to be

prepared to contribute to the recovery by retraining workers, maintaining the highest of

standards of quality and supporting innovation.(CIOB, 2009).

This report attempts to examine empirically the importance of quantity surveyors and

quantity surveying profession in the construction industry as the effective drives to help the

industry in the prevailing recession. Next sections provide a comprehensive definition of

financial crisis, its transformation to economic crisis, and its impact on the construction

industry. The role of Quantity Surveyors in the construction industry is described and finally

importance of the quantity surveyors in the current financial crisis is examined and

highlighted.


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2. Financial crisis and Economic crisis

Before discussing how and why financial crisis occurs and what its relationship to economic

crisis is, it is necessary to have a precise definition of financial crisis. According to Mishkin

(1992), A financial crisis is a disruption to financial markets in which adverse selection and

moral hazard problems become much worse, so that financial markets are unable to

efficiently channel funds to those who have the most productive investment opportunities.

(pp.117-118) Schwartz (1986) proposed another definition as Financial crisis is where there

is a threat to countrys money supply.

Therefore, financial crisis causes the failure of financial markets to function effectively and

efficiently, which lead to a sharp reduction in economic activities. Five primary factors cause

financial crisis namely 1- Increases in interest rates, 2- Stock market declines, 3- Increases in

uncertainty, 4- Bank panics, and 5- Unanticipated declines in the aggregate price

level.(Mishkin, 1992). In Appendix 1, full description of each aforementioned factor is

provided.

Figure 1 shows the sequence of events that happen during a financial crisis and its

development to an economic crisis.

2.1. Analysis of current financial crisis

The current financial crisis began from the US in the third quarter of 2007 when investors lost

their confident in the value of mortgages. Losses of sub-prime loans resulted in a liquidity

crisis amongst the banks leading a bank panic which eventually developed into an economic

crisis. As Peston (2008) describes, the UK, Europe and the US borrowed from Asia and

Middle East in the form of loans. The loans used to buy houses, support property


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development etc, resulted in a sharp rise in the value of assets. This increase in the value was

encouraging more lending which caused further rise of asset prices.

Fig.1. Sequence of events in a financial crisis. The sequence of events above the dashed line are those

that occur in almost financial crisis, while the events below the dashed line occur if a financial

crisis develops into a debt-deflation and consequently economic crisis, (Mishkin, 1992)

Lenders were willing to lend more even up to almost 100% of the purchase price. However, as

Baker (2002) argued, this run-up in home prices was just a housing bubble. He pointed out

that there is no obvious explanation for a sudden increase in the relative demand for housing

which could explain the price rise and there is also no obvious explanation for the increase in

home purchase prices relative to rental prices. Therefore the only plausible explanation for the

Increase in

interest rate

Adverse selection and moral hazard problems worsen

Decline in aggregate economic activity

Increase in

uncertainty

Stock market

decline

Bank panic



Price level

decline



Typical

Financial

Crisis

Debt-Deflation


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sudden surge in home prices is the existence of a housing bubble. This means that a major factor

driving housing sales is the expectation that housing prices will be higher in the future. While this

process can sustain rising prices for a period of time, it must eventually come to an end.

(pp.17-18) As Baker predicted, this bubble burst. Asset prices started to fall down. Declines in

asset prices made trouble for those who borrowed to buy those assets and as they were struggling

to pay their liabilities, they had to sell other assets, causing decline in the price of those assets. As

they couldnt repay banks, the resources of banks were dried out, which means there is less credit

available which decreased asset prices more, which led to additional contraction of lending, and

so on in vicious cycle of decline.(Peston, 2008) thus banks financial intermediation decreased

and resulted in a decline in aggregate economic activity and consequently, an economic crisis.

2.2. The impact of the financial crisis on the construction industry

The construction industry, as most of the other industries, was not immune from the current

financial crisis. Surveys reveal that new orders reduced by 39% in the third quarter of 2008 in

comparison with the average of 2007. Private housing orders fell 62% on the average of the year

before and public housing orders declined by 36%. Private housing starts falling down by

approximately 43% during 2008 and a further 32% decline is predicated in 2009.(CIOB, 2009).

In the UK, the construction industry confronted a workload reduction of 0.7% in 2008 and further

decline of 3.1% is anticipated in 2009. (National Statistic, 2008) Table 1 and Chart 1 provides a

statistical report of Housing situation in England from 1997-2008. The impact of the prevailing

recession on the construction industry can be monitored through the public sector and the private

sector which are discussed as follows:

- Private sector:

A sharp decline in private works makes problems for private construction companies.Table

1 show new house building orders declined from 172,290 in 2006-2007 to 155,880 in 2007-

2008 which means approximately a 10% decline.


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Companies adjusted the Tender Price Index forecasts for 2009 and 2010 by minus percents,

respectively. A considerable number of construction firms found difficulty to access to

capital and a many new projects have been refused new credits.

- Public sector

Public works have a better condition in comparison with private works. Government

decided to spend 3bn of capital on infrastructure. However, risk of delays in

governments projects which will lead to increased under-spend, resulted in rationing the

budget and postponing the less prioritised projects such as Building Schools for Future

Programmes.(CIBO, 2009)

Another impact of financial crisis on the construction industry is falling salaries and job cuts.

Almost 400,000 jobs in the construction sector are predicted to be lost in next two years.

Companies, either public or private, are having to re-structure and down-size to survive

therefore the loss of technical resource and expertise is expected. (CIOB, 2009). Quantity

Surveyors as the construction based professionals also are facing the threat of being made

redundant. Nevertheless, quantity surveyors can play an essential role to help the industry

pass through this recession and allow it to grow after the economy recovers.

Following sections aim to explain the importance of Quantity Surveyors and generally

quantity surveying profession in this dramatic situation.


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Table1. Number of house buildings: permanent dwellings started and completed, by tenure, England,

Source: National Statistic (2008)

Start Completed

Financial

Year

Private

Enterprise

Registered

Social

Landlord

Local

Authorities

All

Dwellings

Private

Enterprise

Registered

Social

Landlord

Local

Authorities

All

Dwellings

1997-98 136,280 19,630 260 156,170 127,840 21,400 320 149,560

1998-99 129,660 17,550 130 147,330 121,190 18,890 180 140,260

1999-00 132,540 15,940 150 148,630 124,470 17,270 60 141,800

2000-01 128,600 12,840 210 141,650 116,640 16,430 180 133,260

2001-02 138,850 11,060 120 150,020 115,700 14,100 60 129,870

2002-03 139,690 10,910 160 150,760 124,460 13,080 200137,740

2003-04 148,770 12,350 280 161,390 130,100 13,670 190143,960

2004-05 159,950 14,390 210 174,540 139,130 16,660 100155,890

2005-06 167,430 17,230 250 184,910 144,940 18,160 300 163,400

2006-07 155,240 16,850 200 172,290 145,680 21,750 250 167,680

2007-08 139,880 15,750 250 155,880 143,590 23,090 310 166,990


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Chart1. Number of house buildings: permanent dwellings started and completed, England


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3. Quantity surveyors competencies

According to a report published by RICS in 1971, the quantity surveyors roll is to ensure that

the resources of the construction industry are utilised to the best advantage of society by

providing, inter alia, the financial management for projects and a cost consultancy service to the

client and designer during the whole construction process. The rapid development in the

profession led the RICS to prepare a new report in 1983 which explored further the work of

quantity surveyors as well as their future potential and directions and suggested an even greater

expansion of services and in some cases in industries other than construction. In 1991, Quantity

Surveyors Division of the RICS commissioned a report, entitled QS 2000-The Future Role of the

Chartered Quantity Surveyor and analysed the threats and opportunities which the quantity

surveying profession may confront namely, changes in the market, changes in the construction

industry, changing client needs and changes in the profession.(Willis et al., 1994). The work of

quantity surveyors are summarised as:

Preliminary cost advice

Cost planning including investment appraisal, life-cycle costing and value analysis

Procurement and tendering procedures

Contract documentation

Evaluation of tenders

Cash-flow forecasting, financial reporting and interim payments

Final accounting and the settlement of contractual disputes

Project management

Specialist services

The RICS indentifies a range of skill and knowledge that the quantity surveying profession needs

to carry on in order to keep its paramount place in the construction industry. The required

knowledge includes:


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Construction technology

Measurement rules and conventions

Financial management

Business administration

Construction law

And the required skills include

Management

Documentation

Analysis

Appraisal

Quantification

Synthesis

communication(Willis et al., 1994)

The RICS also emphasised on the requirements and competencies for assessment of a quantity

surveyor and categorised them into three distinct category namely mandatory competencies, core

competencies and optional competencies

1- mandatory competencies:

The mandatory competencies are common to all professions involved in the construction industry

under the RICS structure and include:

- Personal &Interpersonal skills

- Business skills

- Data, Information and Information Technology

- Professional Practice

- Law

- Measurement

- Mapping ( Nkado,2000)


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2- Core competencies:

The primary competencies of a quantity surveyor include:

- Commercial management of construction or Design economics and cost planning

- Contract practice

- Construction technology and environmental services

- Procurement and tendering

- Project financial control and reporting

- Quantification and costing of construction works. ( RICS, 2008)

3- Optional competencies:

There is a need for flexibility in order to respond to new demands and opportunities. Extended

services of a Quantity Surveyor are mostly technical competencies which focus on future role of

the quantity surveyor. These competencies include:

- Arbitration & Other Dispute Resolution Procedures

- Development Appraisal

- Facilities Management

- Insolvency

- Insurance

- Project Management

- Property Investment Funding

- Research Methodologies and Techniques

- Taxation Allowances and Grants

- Valuation (Nkado, 2000)


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3.1. The quantity surveyors in public and private sectors

In both public and private sectors the quantity surveyors are the important consultants for

employers. Traditionally, the distinctive different between private and public sectors was that

in private sector the main emphasis was on profits while in public sector it was on ensuing

the accountability of public finance. However, over recent years the aims of both sectors

come together which are competing against each other for wok, and their business as well as

profits. (Willis et al., 1994)

3.1.1. Private Sector

The main concern of quantity surveyor in private sector is finding capital and offices,

ensuring a flow of work and avoiding losses. Hence, quantity surveyors have to demonstrate

a detailed expertise in terms of funding and economics and the financial consequences on

particular type of construction projects. (Willis et al., 1994)

3.1.2. Public Sector

The key clients of public sector are mostly government organisations. The public service of

the quantity surveyors includes employment in government departments and agencies

(Department of the Environment, Department of Transport, Department of education,

Department of Health, Property Holdings, Defence Works Services and the Lord

Chancellors Department), local authorities and some statutory bodies.

Quantity surveyors deal with the control of projects in a wide range size from very large to

small minor works, as well as maintenance and repair programmes. The surveyors main

responsibility is that of controlling the public money and monitoring the way that it is being

spent. (Willis et al., 1994)


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4. The key role of quantity surveyors for public sector organisations

In the previous section, a comprehensive description of quantity surveyors competencies in

the both private and public sectors has been provided. As it was analysed the most important

aspect in the financial crisis is cash flow and credit which are indispensable on the

construction industry. It is essential to control and manage these key factors in order to

recover the current crisis specially in the public sector because firstly, public sector deals

with the public fund and governmental budget, secondly, mostly the public sector projects are

the public vital needs such as hospitals, roads and schools; and finally, the public sector

projects are often large scale ones and associated with the intensive capital and budget.

Therefore the quantity surveyors can play an important role with their knowledge and skills.

It is unlikely that a project can be successful without effective reasoned advices and efficient

consultancies of a quantity surveyor during the whole lifecycle of the project.

The quantity surveyor influences on each stage of the public sector projects with his relevant

core and extended competencies. These include the following stages:

- Pre-design stage:

At this stage, the client develops the concept, undertake a feasibility study and prepare an

outline cost plan. An outline brief is then prepared after studying various options for the

project. The brief is then developed which includes the clients requirements such as cost

limits, time limits and functionality of the project. (Egbu, 2009)

The knowledge and skills of the quantity surveyors that can be useful at this stage are:

Project Evaluation: this competency is comprised development appraisal, investment

appraisal, cost benefit analysis and financial aspects of feasibility study. The quantity

surveyors have comprehensive knowledge of the various elements of the feasibility


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study and development appraisal and the factors that can affect them. Their

understanding of techniques used to assess financial viability, enable them to advise

the clients on the economics of design, on the use of value management and on how

to consider risks associated with the project.

Design economics and cost planning: quantity surveyors can give strategic and

reasoned advice to the clients on diversity of market factors and trends in construction

cost. They have knowledge of the main parameters that affect design economics over

the whole life cycle of projects and thus they can assist in the financial control of

projects from feasibility to design completion by evaluating the efficiency of the

design. They prepare preliminary estimate and cost plans at this stage; and analyse the

accuracy of predicted cost.

Procurement advice: quantity surveyor is regarded as advisor or experts on selection

of procurement methods and the advantages and disadvantages of each to the parties

involved. They therefore have a clear knowledge of the main types of procurement

used in the public sector and also ancillary processes such as partnering and

framework agreements. They can evaluate the appropriateness of various procurement

routs and implementing them. ( RICS, 2008)

- Design stage:

During this stage, design team develop the brief into drawings and specifications. Client is

informed of possible cost changes and can then change items of the design to reduce costs or

accept the increased figure. (Egbu, 2009)

The following competencies are used during this stage by quantity surveyors:


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Construction technology and environmental service: understanding and knowledge of

different stage of design from inception to completion is one of the quantity

surveyors competencies that can be used during the design stage. Quantity surveyors

advise on the impact of different design solutions on cost and programme. They

appreciate how design solutions vary for different types of buildings; thus can give

effective advice on the choice of design solution for projects

Contract management: this competency covers the role and responsibility of a

surveyor managing the construction contracts. Quantity surveyors have detailed

knowledge of the contractual provisions relating to the various standard forms of

contracts. They can advise on the most appropriate contractual procedure at the

various stages of a contract and then evaluate the appropriateness and implication of

proposed contractual amendments. They assess entitlement for extension of time, loss

and expenses; finally giving advice to clients of their contractual rights and

obligations. ( RICS, 2008)

Value management: employers are now looking for achieving improved value for

money. Values of a project vary from perspective of each parties involved in the project.

In the public sector projects, values are not only the cost and commercial aspects. Other

factors such as aesthetic aspects, sustainability issues, extendibility and easy-remodelling

capability should be taken into account and by considering of the fact that value is related

to cost; quantity surveyors therefore are involved in the value management. Quantity

Surveyors have the potential to act as the Value engineering coordinator, the key person

in the team and also in their traditional role as cost consultant..... Value engineering

provides a method of integration in the building process that no other management

structure in construction can provide...Value engineering complements Project

Management. (Kelly et al., 1998)


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- Construction stage:

At this stage, execution and control of all site work and associated activities are carried out.

Site supervisors monitor the project to ensure the project is constructed as per the contract

documentation. The clients representative meanwhile is responsible for the management of

all aspects of the construction stage, including monitoring the work of the design leader and

supervisor. (Egbu, 2009). Presence of quantity surveyors has the significant affect on the

project. The following skills and knowledge can lead the project to the best and optimal rout:

Quantification and costing of construction works: this competency includes the

measurement, valuation and definition of construction works in order to value and

control costs which is another important part of quantity surveyors work. Surveyors

carry out the quantifying and pricing construction works at various stages of projects;

using their thorough knowledge of the various standard methods of measurement and

also have this ability to advise clients on appropriate method of measurement and

costing.

Conflict avoidance, management and dispute resolution management: this skill is

comprised the procedure and techniques for conflict avoidance, conflict management

and dispute resolutions. The quantity surveyor has an in-depth knowledge of how

various forms of contract deal with dispute avoidance and their provisions for

resolving disputes. They can give advice on law governing conflict avoidance and

management and can assist clients by their knowledge of dispute resolution procedure

within construction process including: negotiation, mediation and conciliation,

adjudication, arbitration, independent expert determination and litigation.(RICS,2008)

Commercial management of construction: quantity surveyors have a thoroughly

understanding of the financial processes used to achieve profitability and how these


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processes integrate with the overall delivery of the project. They are aware of

techniques to reconcile the cost against income and therefore manage sub-contractors

and suppliers financially. They evaluate and advise on the financial implications and

appropriate management actions. Monitoring, analysing, reporting and advising on

project cash flow and profitability are the other quantity surveyors competencies that

clients can benefit from.

Project management:. The quantity surveyor is not only regarded as a building or a

civil engineering estimator but he is also can be appointed as project manager, to take

control of the project from inception to completion and to organise the work of the

design team and the main contractor and subcontractors. (Seeley, 1997). Basically,

management of project starts from design stage and continues through construction

stage of project. Knowledge of risk management, planning and programming enable

a quantity surveyor to be appointed as a project manager. Ability of a quantity

surveyor to identify risks associated with the project and his knowledge of the

strategies to eliminate or mitigate them are the key competencies for managing a

project. ( RICS, 2008)

- Post-construction (Use) stage:

At this stage, project is handed over and information for feedback is obtained. Although

almost all design and construction parties are not involved in this stage, quantity surveyors

still can play a key role during this stage by the following competencies:

Life-cycle cost advice: life cycle cost of a project is defined as the whole life cost of the

project from the very beginning phase through post-construction and use phase including

maintenance and service costs. However, the major part of life cycle cost is related to use


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phase when the project is commissioning and operating. It is wholly dependent on the

functionality of that project, for example, life cycle cost of a dwelling house is

completely different from a workshop even though their design and construction cost

were the same. As the life cycle cost of a project does not appear before operation and use

phase, it does not affect on the design and construction stage therefore usually it is not

considered during these phases. However, as mentioned before, the major cost of a

project is likely to be related to the post-construction cost and thus has a significant

impact on projects; especially in the public sector due to the nature in which provides

services to public such as schools, hospitals, health centres and so on. Hence it is essential

for public sector projects to consider the maintenance and service and generally life cycle

cost of them. Quantity surveyors have the competency to estimate and evaluate the

lifecycle/whole life cost of a project. They carry out life cycle cost exercises which take

account of value management, value engineering, risk management and sustainability

issues.

Finally, quantity surveyors have an important role in improving the effectiveness of

managing the public projects by their knowledge of processes associated with project,

information and knowledge management. Skills of quantity surveyors in the field of

contractual policy, by the application of such techniques as serial tendering, early contractor

selection, and statistical measurement of price movement and effective mechanisms of

budgetary control, all play a large part in the survival of public sector from the current

financial crisis. (RICS, 1973)


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5. Conclusion

Quantity surveyors have an essential part to play in increasing the efficiency of construction

work and reducing confrontation by securing that the most appropriate procurement method

is appointed, providing effective cost control procedure and ensuring value for money at all

times. They minimise the potential omission by allocation risk and identifying the value-

adding activities in the project. Quantity surveyors operate a wide range of competencies

outside the traditional quantity surveying activities. The extended skills of quantity surveyors

such as project management and value management also help clients to achieve their needs

and expectations.(Seeley, 1997) in the current financial crisis which cash flow and credit are

paramount factors for clients, an effective project management is essential, thus completion

of project on stipulated time and within determined budget is important specially in the public

sector which deal with the large scaled projects and intensive capital. Quantity surveyors

have this capability to secure success of the projects by their effective technical and financial

advices and thus have vital contribution in economic recovery.


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References:

Baker, D. (2002) The Run-up in Home Prices: Is It Real or Is It Another Bubble?, Challenge,

Vol. 45, Issue 6.

Bernanke, B.S (1983) Non-monetary effects of the financial crisis in the propagation of the Great

Depression,American Economic Review, Vol. 73, Issue. 3

Bernanke, B.S and Gertler, M. (1990) Financial fragility and economic performance, Quarterly

Journal of Economics, Vol. 105, Issue. 1

Calomiris, C.W. and Hubbard, R.G. (1990) Firm Heterogeneity, Internal Finance and Credit

Rationing,Economic Journal, Vol. 100, Issue. 399

CIOB (2009) the impact of the global financial crisis on the construction industry,

http://www.ciob.org.uk/filegrab/JAN009_POLICY_credit-crunch-brief_v6.pdf?ref=1134,

(Accessed on 12/05/09)

Davis Langdon & Everest (1991) QS 2000: The Future Role of the Chartered Quantity

Surveyor, London: Royal Institution of Chartered Surveyors.

Egbu, C.O. (2009), process and project systems module handout, Learning Package 2, The

School of Built Environment, University of Salford

Fisher, I. (1933) The debt-deflation theory of Great Depressions,Econometrica,Vol 1.,Issue. 4

International construction intelligence (2009), Faithfull + Gould publication, Vol.21, issue 1.

www.fgould.com/media/resources/files/ICI_First_Quarter_2009.pdf(Accessed on 10/05/09)

Kelly,J., Bowles, G. and Fernie, S. , Male,S. and Gronqvist, M. (1998), The global

development of Value Management : with particular reference to the public sector ,

mandatory requirements , standards and qualifications, London: Royal Institution of

Chartered Surveyors.

Mishkin, S. F. (1992) Anatomy of financial crises, Evolutionary Economics, Vol. 2, Issue.2.

National Statistic (2008),Housing in England 2006/07: A report based on the 2006/07

Survey of English Housing, carried out by the National Centre for Social Research, London:

Department for Communities and Local Government
http://www.ciob.org.uk/filegrab/JAN009_POLICY_credit-crunch-brief_v6.pdf?ref=1134http://www.ciob.org.uk/filegrab/JAN009_POLICY_credit-crunch-brief_v6.pdf?ref=1134http://www.fgould.com/media/resources/files/ICI_First_Quarter_2009.pdfhttp://www.fgould.com/media/resources/files/ICI_First_Quarter_2009.pdfhttp://www.fgould.com/media/resources/files/ICI_First_Quarter_2009.pdfhttp://www.ciob.org.uk/filegrab/JAN009_POLICY_credit-crunch-brief_v6.pdf?ref=1134


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Nkado, R.N. (2000), competencies of professional quantity surveyors in a developing

economy, Proc. of 2nd international conference on construction in developing countries:

challenges facing the construction industry in developing countries, 15-17 Nov, Gaborone

Botswana,http://buildnet.csir.co.za/cdcproc/docs/2nd/nkado_rn.pdf,

(Accessed on 15/05/2009)

Peston, R. (2008), the new capitalism, BBC report 8 December, bbc.co.uk/robertpeston,

www.wtf.org.uk/documents/thenewcapitalism_001.pdf(Accessed on 10/05/09)

RICS (1983) The Future Role of the Chartered Quantity Surveyor, London: The Royal

Institution of Chartered Surveyors.

RICS (1971) The future Role of the quantity Surveyor, London: The Royal Institution of

Chartered Surveyors.

RICS (2008) Your path way to qualify in Quantity Surveying in Construction, London: The

Royal Institution of Chartered Surveyors.

Schwartz, A.J. (1986)Real and pseudo-financial crises. In: Capie, F. and Wood, G.E (eds.)

Financial Crises and the World Banking System. London: MacMillan

Seeley, I.H. (1997) Quantity Surveying Practice, 2nd

ed., London: MacMillan Press Ltd

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Surveyor, 10th ed., Oxford: Blackwell Science
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Bibliography:

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construction and property sectors, RICS Research paper series, Vol.7 Number 20

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Appendix 1: primary factors causing financial crisis

1- Increases in interest rate:

As Stiglitz and Weiss(1987) describes, some lenders cut down the number of loans even

borrowers are willing to pay higher interest. This occurs because lenders believe that

individuals and firms with high-risk investment projects are those who are willing to pay high

rate interest, thus it increases the possibility that the lender is lending to a bad credit risk. If

the borrowers cannot be discriminated by the lender in terms of whether their projects are

riskier investment projects, they are likely to be denied loans. Hence, even if there is an

excess request for loans, a higher interest rate will not be able to balance the market because

further increases in the interest rate will reduce the supply of loans and make the demand for

loans higher. This credit rationing helps creation of a financial crisis because lenders want to

make fewer loans which lead to a significant decline in investment and economic activity in

its totality.

2- Stock market declines:

The use of collateral is an important way that the borrower can make the lender confident to

supply loans because it reduces the lenders losses in the case of default. If a borrower evades

the loan, then the lender can take the collateral and sell it to compensate the losses on the

loan. Net worth plays the same role to collateral. If a firm has high net worth, then if it

defaults on a loan, the lender can take title to the firms net worth and sell it to make up for

some of the losses on the loan. Hence, when firms have high net worth, lenders will be more

willing to make loans. Calomiris and Hubbard (1990) emphasised that a decline in the stock

market leads to a large decline in the market value of firms net worth thus the decline in net

worth as a result of a stock market decline makes lenders less willing to lend. Therefore the

stock market declines result in a decrease in lending and a decline economic activity.


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3- Increases in uncertainty:

An increase in uncertainty in financial markets makes difficulty for lenders to distinguish a

bad credit risk investment from a good one, leading them to a decline in lending and

investment

4- Bank panics

Financial intermediaries that make private loans such as banks, have an important role in

financial markets. Banks by becoming expert in the production of information about firms

can discriminate good credit risks from bad ones. Then they attain funds from depositors and

lend them to good firms. Because banks are able to lend to good firms, they can revenue on

their loans higher than the interest they pay to the depositors so they are able to earn a profit.

As Bernanke (1983) described, a financial crisis which resulted from a bank panic reduce the

amount of financial intermediation undertaken by banks, and will lead to a decline in

investment. The bank panic occurs when depositors, fearing the safety of their deposits, rush

to make withdrawal their deposits from the banking system causing a contraction in loans and

a multiple contraction in deposits. Banks thus try to protect themselves from deposit outflows

by increasing their reserves relative to deposits which produces additional contraction in

loans and deposits and precipitate other banks failure.

5- unanticipated declines in the aggregate price level:

As debt payments are contractually fixed, unanticipated declines in price level raises the

value level of firms liabilities but does not raise the real value of firms assets. The result is

that the net worth in real terms declines and as discussed before decreasing the net worth

makes lenders less willing to lend and consequently causes a decline in investment and

economic activity. (Mishkin, 1992).

As pointed out by Bernanke and Gertler (1990), typically a financial crisis begins with an a

stock market failure, excessive rise in interest rates, and increasing uncertainty caused by


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crash of big financial firms. During these crises, the increase in uncertainty, the rise in

interest rates and the crashing stock market, intensify the problems in credit markets which

make it less willing for lenders to lend and cause a decrease in lending and investment.

Depositors begin to withdraw their money from banks because of deteriorating business

conditions and hesitation about their banks health. The resulting of bank panic increases

interest rates even higher and decreases the amount of financial contribution by banks which

leads to economic contraction.

If the economy downturn causes a sharp decrease in prices, the decline in the price level leads

to devalue firms net worth. This situation defined by fisher (1933) as debt-deflection period

and makes economic activities remain depressed for a long time

Documents

Importance of QS in Public Organ is at Ions in the Prevaling Recession