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Federal Reserve Study Paper #666

On October 23, 2008 the research department of the Federal Reserve Bank of Minneapolis issued an important paper. Its title is "Facts and Myths about the Financial Crisis of 2008."

The authors of this paper do not dispute that the United States is going through a financial crisis as witnessed by major financial institutions having failed and the fact that various stock markets have fallen dramatically. They strongly disagree, however, with the most widely voiced claims about the nature of the crisis and the extent to which the problems of the financial sector are spilling over to the rest of the economy.

Four primary claims have been made about the current crisis by financial institutions themselves, public policymakers and the financial press, as follows:

Bank lending to nonfinancial corporations and to individuals have declined sharply. Interbank lending is essentially nonexistent. Commercial paper issuance by nonfinancial corporations has declined sharply and rates have risen to unprecedented levels. Banks play a large role in channeling funds from savers to borrowers.

Using data from the Federal Reserve Board itself through October 8, 2008 the authors of this myth shattering paper vigorously dispute all four of these claims. They show that aggregate bank credit has not declined during the financial crisis and, in fact, that total bank credit available actually increased in September of 2008.

Along the same lines, the paper shows that loans and leases made by U.S. commercial banks have not declined during the financial crisis nor have commercial and industrial loans to nonfinancial businesses. Finally, data for consumer loans highlighted in the paper show no evidence that the financial crisis has affected consumer lending. All of the figures cited prove that the first claim about the impact of the financial crisis — bank lending of all kinds has declined sharply — is false.

Data found in the paper regarding interbank loans by all U.S. commercial banks demonstrate that "at least in the aggregate" interbank lending is healthy and has not been adversely affected by the financial crisis. Thus, the second claim made about its impact is false on its face.

With respect to the commercial paper market, the authors point to data that shows that such issues by financial institutions have declined, mostly because huge increases in customer deposits have lessened the needs of banks to raise money in this way. On the other hand, commercial paper issued by nonfinancial institutions has been essentially unchanged during the financial crisis. Also, the authors maintain that interest rates on commercial paper have "barely budged." The third claim about the financial crisis — that the commercial paper market has dried up and the interest rates on such issues have risen dramatically — is a myth, to put a kind face on the nature of these claims.

Finally, the paper explores the nature of bank lending to nonfinancial corporate businesses and concludes that such lending does not constitute the bulk of borrowing of these businesses. In the second quarter of 2008 direct bank lending to businesses totaled $1 trillion. Funds obtained by nonfinancial corporate businesses through the issuance of public corporate bonds, however, is currently four times as great (at $4.5 trillion) as the total from direct bank lending to these companies. Obviously, banks do not play the most major role in channeling capital to businesses and the fourth claim about the nature of the current financial crisis is proven to be false by this paper.

The authors also discuss the abnormally high spread between Treasury bill interest rates and those of short-term corporate debt issues. Since — as we have seen — the latter interest rates have remained stable, the spread is due to the historically low rates currently being paid on treasury bills. If one compares, on the other hand, interest rates paid on investment-grade corporate bonds to those paid on Treasury bonds of similar maturities, the spreads between them has remained at historic norms throughout the financial crisis. Once the current panic over short-term interest rate spreads and so forth subsides, Treasury bill interest rates can be expected to rise to more normal levels.

So, if the major claims about the impact of our country's financial crisis are myths and/or lies, why all the panic? Do the financial institutions most affected by the crisis (i.e., investment banking firms and those commercial banks truly in trouble), public policymakers and the financial press not know the facts or have they deliberately kept them from the American people? Have we been stampeded into the Panic of 2008 and, if so, why? Will some benefit much, much more than others of us from this stampeding?

October 27, 2008

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