Credit Crunch: are you legally protected? A survey

Publication | April 2008


The effects of the “credit crunch” are now pervasive in the financial markets and are increasingly evident in the wider global economy. There is a very real prospect of a US recession which could affect the whole world.

The cycle has turned with remarkable speed. Even a year ago, the capital markets were booming and M&A was reaching record heights, partly thanks to a surge in private equity-backed buyouts in the US and in Europe.

Now all that has unravelled spectacularly. Cheap debt encouraged not only excessive sub-prime lending and mortgage securitisation but also “covenant-lite” deals which tended to favour the borrower in LBOs. The huge write-downs that have followed have led to a poor series of results in the financial services sector. Total write-downs at financial institutions are forecast by analysts to reach between $285 billion and $600 billion. Nervousness among banks has led to sharp cuts in lending, moves which have caused a severe slowdown in M&A, including the virtual closure of the LBO market. We have also seen the first run on a UK bank since the nineteenth century, the demise of one of the best known Wall Street banks and volatility in global stock markets.

Searching questions are now being asked about the way financial institutions and markets operate, how they are regulated and whether institutions and firms are legally protected against the results of the credit crunch. The markets are also still assessing how severe and widespread the repercussions of the liquidity crisis will be. In any event, this crisis will demand substantial reforms and a huge effort to rebuild confidence.

This survey set out to canvass opinion in four main areas: the causes of the credit crunch, its consequences, market conditions and the future.

Executive summary

The results of this survey show that the market is realistic about the credit crunch and is not shying away from radical measures to deal with it. Respondents, even though many of them work in the industry themselves, blamed financial institutions, especially in the US, for the credit crunch. A majority believed that banks made poor business decisions, and that banks did not have adequate risk management processes in place. Many also said that poor lending regulations in the US contributed to the crisis.

One of the major consequences of the crisis will be, according to the vast majority, a rise in litigation. This is already starting to happen, principally because people failed to understand the true nature of the complex transactions in which they were involved, and partly because of a commercial need to re-coup losses. There would also be a significant need for debt restructuring in the financial services sector. A further consequence of the crisis, in the view of a large minority, is likely to be a shift in the way bankers are remunerated, away from short term bonuses and towards long term incentives.

Respondents were alive to the fresh opportunities presented by the market conditions following the crunch. Many believed that the BRIC countries (Brazil, Russia, China and India) were in the process of decoupling from the West, and emerging markets in general were seen as one of the most attractive asset classes in which to invest. Attitudes to sovereign wealth funds (SWF) varied, but significant numbers said their boards would be willing to consider offers from them, and a majority said that they would not rule out an offer from a SWF simply because of the country of its origin.

Respondents believed, however, that the market would not stabilise for some time to come. Nearly half said the credit markets would take over 11 months to settle down.

The survey revealed that many in the market were reconciled to some tough regulatory measures to resolve or alleviate the effects of the crisis. Over half agreed that lead regulators and central banks should be given more powers to intervene in the management of financial institutions.

The causes of the credit crunch

The origins of the credit crunch lie in US  sub-prime lending, the excesses of which were fuelled by low interest rates. Banks and other financial services firms also exposed themselves to problems in this market by creating and investing in structured products which re-packaged pools of mortgages. “Triple A” ratings for many of these products could not disguise the poor quality of a critical portion of their assets. Although errors have also been committed elsewhere, the conventional, publicly expressed, view is that institutional failures in the US are at the heart of the problem, and fingers have been publicly pointed both at senior financial institutions executives in the US, some of whom have been forced to resign, and at their risk management systems in general.

Our respondents generally supported such a view, although few blame individuals and many also highlight the role of the regulators. A substantial majority of them (73 per cent) blame financial institutions themselves for the problems, even though many of the respondents themselves work for such institutions.

Few blamed individual bankers, despite some high-profile resignations. When they were asked to identify the causes of the credit crunch, 55 per cent pointed to “poor business decisions by banks”, and 38 per cent cited poor lending regulations in the US. A damning 56 per cent believed that banks and other financial institutions did not have sufficient risk management processes in place. Such processes were perhaps being overwhelmed by the lure of lavish, if short term, rewards. A noticeable minority simply cited “greed” as the root cause. As explained further below, there was a growing call for a change in the way bankers are remunerated.

Who do you think is ultimately to blame for the credit crunch?
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The greatest impact of the crisis (according to 87 per cent) was being seen in the US. Yet overall the responses suggest that it is not only banks and regulators in the US who will be spending much time consulting, reflecting and repairing their systems following the crisis.

Banks will need to re-assess their entire approach to risk management, which is now coming under fire not just from old school bankers who might be unfamiliar with modern structured products but also from much less risk-averse ones. We have already seen banks replacing or moving their risk management experts in response to the crisis, and of course lending policies have been tightened considerably.

More measures will need to be taken in the future, especially in the drafting of lending terms. “Covenant lite” leveraged deals helped to maintain the pace in the LBO  markets, but they have been damaging to banks in tilting the balance in favour of the borrower. A way needs to be found of re-opening the LBO market while avoiding excessive risk taking by banks.

Banks might also have to prepare for closer regulation and will have to change their compliance regimes accordingly.

A small if noticeable minority philosophically cited the “inevitable economic cycle” (11 per cent) as one of the causes of the credit crunch, and it has to be said that bubbles are nothing new: it is the severity of the explosion which is unusual.

To what do you attribute the credit crunch?
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The consequences of the credit crunch

The fall-out from the credit crunch has been painful and it could spread much further. There have been some well-publicised litigation cases, including some in Europe, and there will have been many more instances of parties settling issues busily but quietly among themselves in order to avoid damaging publicity, expensive court cases, and ruptures in otherwise fruitful business relationships. Redundancies, especially at banks, have been another consequence, although the timing of them is ironic since record bonuses for 2007 were awarded to some over the last few months.

Do you think banks and other financial institutions have sufficient risk management processes in place?
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Most commentators agree there will be many more litigation cases and job losses to come. Debt restructuring, which can be expected to gather pace during a downturn, is also set for a revival after a typically quiet period during the recent boom. But there is still great uncertainty in the markets and the liquidity crisis is not affecting everyone in the same way.

Among our respondents, however, there is very little disagreement about the impact on litigation. A large majority of them (79 per cent) believed that the credit crunch would lead to increased litigation. A mere 5 per cent responded with a firm “no.” There was a range of answers as to why there should be such a rise, although a majority (55 per cent) said it was because of a “lack of understanding of the structure of the underlying transaction”. There is plenty of anecdotal evidence that for instance, even some finance professionals do not understand structured products as well as they should. Forty-seven per cent said it was because of a lack of understanding of the risks, and a further 29 per cent mentioned a “mis-pricing of risk”.

Thirty-two per cent offered the seemingly cynical but highly plausible view that there was a commercial opportunity to re-coup losses at a time of scarce liquidity. Mis-selling (27 per cent) and poor quality documentation (18 per cent) were also frequently cited, and fraud (7 per cent) crept in.

Do you think the credit crunch will result in increased litigation?
Bar chart showing results


Respondents also agreed that litigation cases had already started (27 per cent) and that more would follow in the next 3–6 months (nearly 50 per cent). Only 2 per cent said “they won’t start happening.” More surprisingly, however, our respondents were more optimistic about job cuts than many people in the financial services industry. Over half (53 per cent) said they did not believe their organisations would make redundancies in the next 12 months, although a substantial minority (36 per cent) said they did. This clashes with recent estimates in the Financial Times that headcount would be reduced by about 15 per cent in the US and European investment banking industry.

The survey confirms there is a growing body of opinion which favours a change in the way bankers are remunerated. Forty-two per cent said there should be a shift away from short term bonus plans towards longer term share incentive plans. Some 40 per cent came out firmly against it, but it is likely that the credit crunch is altering some opinions. Questions are being asked about the way bankers are remunerated. Interestingly, the Institute of International Finance, a global group of banks, is seeking to establish a code of best practice that discourage banks from rewarding their employees for taking excessively risky bets on the market.

Market conditions following the credit crunch

Financial institutions and corporates alike are seeking alternative sources of capital and liquidity, notably from sovereign wealth funds in the emerging markets. Some of them, especially banks, have already agreed to injections of capital from sovereign funds in the Middle East and Asia and now such funds are even being held out as possible sources of debt finance for the moribund LBO  market.

Do you think your organisation will have to make redundancies as a result of the credit crunch in the next 12 months?
Pie chart showing results


Publicly expressed opinions suggest there is a certain amount of scepticism, even suspicion, about their intentions and their capacity to provide finance, and the funds themselves might be reluctant to invest further in faltering banks and private equity firms.

This survey suggests that existing investors and shareholders rather than sovereign wealth funds are the first source to which respondents would turn, but a substantial minority (23 per cent) said their boards would be likely to consider an offer from the latter. A number (32 per cent) also said, however, that there were certain regions and jurisdictions from which they would not consider offers.

There has also been much discussion about the extent to which emerging markets, especially the BRIC (Brazil, Russia, India and China) countries are decoupling. This is important because some experts argue that these economies are no longer dependent on Western markets and that demand and liquidity in their own markets will insulate them from the West’s credit crunch, and even help them to relieve problems in the West.

Our respondents are as sharply divided on this question as everybody else. While 45 per cent believed they were in the process of decoupling, some 38 per cent firmly disagreed while a considerable minority (18 per cent) were undecided.

Do you think there will be a shift away from short term annual bonus plans to longer term share incentive plans in light of the credit crunch?
Pie chart showing results


The respondents were less divided on the prospect of a recession since they demonstrated a heartening degree of optimism. While pessimism about the US  might be rife, not everyone in Europe is expecting things to be so bad. Some 59 per cent said they did not expect a recession. This is in line with recent opinions expressed by, for instance, senior officials at the European Central Bank.

Nonetheless, they accepted that market conditions had changed. Investors are searching for perceived safer options: more respondents favoured emerging markets (38 per cent), property (28 per cent) and commodities (25 per cent) over equities (20 per cent) or bonds (17 per cent). They would have been influenced by the fact that Latin American and Asian GDP  growth rates have been boosted by buoyant commodity prices.

The future

Our respondents also accepted that market conditions would not improve for some time to come. Forty-nine per cent said it would take over 11 months for the credit markets to stabilise and 38 per cent said it would take 7–11 months. Only 1 per cent said they would settle in the next three months.

When do you expect the credit markets to stabilise?
Bar chart showing results


The economic consequences of the credit crunch could be serious but, so far, there is no evidence to believe they will be cataclysmic. But the uncertainty and lack of confidence about the future will cause deleveraging, or cutting of debt levels among banks, and that in itself will have adverse consequences.

As well as being unsettled, the respondents were also reconciled to a future that would be more closely regulated. Fifty-three per cent agreed that lead regulators or central banks should be given more powers to intervene in the management of financial institutions. Although plenty disagreed (38 per cent) the signs are that events on the ground, rather than simply faith in the workings of the free market, are heavily influencing opinion.

Do you agree/disagree that lead regulators or central banks should be given more powers to intervene in the management of financial institutions?
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The regulators and central banks have been active in trying to mitigate the effects of the crisis and, when they have been criticised, it has tended to be for inactivity or indecisiveness rather than over-zealous interventionism.

The responses here reflect a revolution of opinion in progress.


Norton Rose LLP surveyed 112 respondents (comprised of financial institutions and other mainstream corporate entities) in February and March 2008 to assess the impact of the credit crunch and gauge reaction to the legal risks. The survey was conducted online and respondents were given the option to remain anonymous.



James Bateson

James Bateson