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short essays and reports on the economic issues of the day
2009 ■ Number 11

Putting the Financial Crisis and Lending Activity
in a Broader Context
Kevin L. Kliesen, Economist
ome economists, policymakers, and pundits view the
financial turmoil that began in August 2007 as the
worst financial shock to the U.S. economy since the
end of World War II. Some even assert that it amounts to
the worst financial crisis since the 1930s. Accordingly, the
Federal Reserve and other government agencies have taken
aggressive actions to support the financial system and spur
economic growth. Other economists and analysts, citing
continued modest loan growth and relatively few bank failures last year (compared with, say, the late 1980s and early
1990s), do not share this view. Regardless, many banks have
announced sharp earnings declines, and the possibility of
further financial losses looms large.
A well-functioning financial sector is crucial to the
performance of the U.S. economy. In a market-based
economy, the financial sector channels the supply of funds
from savers to the demands of borrowers, which supports
the wealth-creating abilities of the entrepreneurial sector.
At the same time, the performance of the financial sector
also depends crucially on the health of the U.S. economy.
Typically, growth of loans and leases at commercial banks
declines sharply before a recession.
Clearly, bank actions to limit the credit supply can
exacerbate an economic downturn. For example, banks
typically tighten credit standards and/or loan terms as the
economy weakens and nonperforming loans increase. But
an adverse shock from outside the financial sector can be
just as important—such as a sharp increase in oil prices or
a plunge in house prices. Such shocks also slow the demand
for credit because of weaker future growth of incomes and
profits. In large and open economies, forces that trigger
changes in the supply and demand for credit are often
synchronized and difficult to distinguish.
Thus, it is not surprising that bank loans slowed when
GDP growth slowed: When GDP averaged 2.7 percent for
2004-07, the growth of bank loans averaged 11.4 percent
per year; when GDP fell slightly in 2008, growth of bank
loans slowed to 5.6 percent. Most forecasters expect reces-


sionary conditions through the first half of 2009, so continued weak growth of bank loans is likely. Indeed, in the
1990-91 and 2001 recessions, the year-to-year percentage
decline in bank loans did not reach a trough until February
1993 and March 2002, respectively.

“Banks typically tighten credit standards
and/or loan terms as the economy
weakens and nonperforming loans
increase. But an adverse shock from outside the financial sector can be just as
important—such as a sharp increase in
oil prices or a plunge in house prices.”
Other factors have weakened household and business
spending in the current recession and thus have adversely
affected the supply and demand for bank loans. A 52 percent drop in the S&P 500 stock price index from October 9,
2007, to November 20, 2008, accompanied the oil shock
and fall in house prices. Accordingly, household net worth
(financial and tangible net wealth) fell by about $7 trillion
between 2007:Q2 and 2008:Q3. Another key factor has been
the simultaneous slowing in economic growth in most of
the world’s largest economies, which is important because
exports were a key source of U.S. economic growth in
Some claim the key cause of slower growth has been
the losses and write-downs incurred by banks and other
financial institutions that hold asset-backed securities (ABS)
on their balance sheets.1 In particular, prices of nonprime
mortgage–related ABS have plummeted in part because of
rising mortgage defaults and foreclosures stemming from
falling house prices and a weakening economy. Because
many of these ABS are no longer actively traded, determining their price—and thus the impact on the banking system’s

Economic SYNOPSES

Federal Reserve Bank of St. Louis

lending capacity—has been a key source of the uncertainty
in financial markets. As a result, many firms have been
extremely cautious in lending because of the perceived risk
in lending to parties who may have substantial ABS losses.
Some estimate that these losses may eventually exceed $2
trillion, but even those estimates depend importantly on
the pace of economic recovery. Moreover, not all firms hold
ABS on their balance sheets, so the perception of increased
credit risk—arising in part from poor macroeconomic
conditions—has affected markets more broadly.
A report prepared for the 2008 U.S. Monetary Policy
Forum argued that the financial crisis will begin to wane
when (i) banks and other financial institutions can raise


enough new equity capital to improve their balance sheets
and (ii) risk and uncertainty recede enough that firms are
less reticent about making loans.2 A more stable macroeconomic environment will go far toward achieving this
outcome. ■

This development is a by-product of the securitization of a wide swath of the
U.S. credit markets that has created a so-called shadow banking system.


Greenlaw, David; Hatzius, Jan; Kashyyap, Anil, K. and Shin, Hyun S. “Leveraged
Losses: Lessons from the Mortgage Market Meltdown.” U.S. Monetary Policy
Forum Report No. 2, 2008;

Posted on February 19, 2009
Views expressed do not necessarily reflect official positions of the Federal Reserve System.