Bank Lending growth is not evidence that there is no crises

By Spencer

I just posted this in the comments at Marginal Revolution to explain why the view that expanding bank lending demonstrates that their is no crises is incorrect.

By looking at bank lending you are looking at the wrong side of the bank’s balance sheet. The point that bank lending is expanding is not a sign that their is no credit crunch. Rather it is an indicator that the Fed actions over the last year to provide large scale financing to the banking system is working.

The crises is not on the asset side of the banks balance sheet. Rather it is in the liability side of the balance sheet where they raise the funds to finance their loans and/or investment. To keep it simple this consist of three items.One is deposits. Two is borrowing in the money markets. Three is borrowing from the Fed.

The crises has been the contraction in the banks ability to borrow in the money markets as evidence by the drop in financial commercial paper and other short term instruments. Everything the Fed has done over the last year to provide special financing to the banks has been to offset or counterbalance the banks inability to funds their operations in the money markets. The fact that bank lending is still rising demonstrates the success of the Fed undertaking its lender of last resort. So again, the growth in bank lending does not demonstrate that their has been no crises. Rather it demonstrates the Fed success in dealing with the crises.

Why are firms borrowing? One of course, is to draw on lines of credit to offset their inability to raise funds in the money market. The second goes to the point that bank credit is a lagging indicator. In the early stages of a business downturn business credit demands typically surges. This stems from the point that their normal source of a positive cash flow, sales are drying up as demand contracts. But because sales are contracting they have to finance an unusual surge in unwanted inventories and their normal day to day expenses such as payroll. Until firms can dispose of their unwanted inventories and cut expenses they have to expand their use of credit. This is why credit demand normally expand sharply in the early stages of a business downturn and why bank lending is typically a lagging indicator. This typical early business cycle behavior is exactly what we are now seeing. This did not happen in the last cycle because it was not a typical cycle. It was caused by a collapse in capital spending, not by a contraction of consumer spending as we are now seeing.