Effect Of Debt Crisis On Credit Markets And Banking System

It was in September 2008, that the effect of debt crisis on credit markets and banking system was seen in its most critical stage. The equivalent of a bank run on the market mutual funds money was observed, which commonly invest in commercial paper issued by companies to finance their businesses and payrolls.

 There was a pulling out of 145 billion during one week, from the credit markets as compared to $7 billion the week before. Such was the serious effect of debt crisis on credit markets. This disrupted the ability of corporations to replace their short-term debt. This lead to the U.S. government to extend insurance for money market accounts equivalent to bank deposit insurance via a short-term guarantee and with Federal Reserve programs to buy commercial paper.

A $700 billion emergency assistance was proposed by Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke, in an emergency meeting on September 18, 2008. Bernanke reportedly told them: "If we don't do this, we may not have an economy on Monday."  On October 3, 2008, the Troubled Asset Relief Program (TARP), was signed into law by the Emergency Economic Stabilization Ac.

The effect of debt crisis on banking system was seen in the growth of the shadow banking system, to nearly equal the importance of the traditional commercial banking sector. This was looked upon as a crisis by economist Paul Krugman and U.S. Treasury Secretary Timothy Geithner. The inability of obtaining investor funds in exchange for most types of mortgage-backed securities or asset-backed commercial paper, resulted in the helplessness of providing funds to mortgage firms and other corporations by investment banks and other bodies in the shadow banking system.

The impact of debt crisis on credit markets and banking system is indicated by nearly one-third of the U.S. ending mechanism remaining frozen into June 2009. According to the Brookings Institution, the traditional banking system does not have the assets to fill this gap as of June 2009.  The authors said "It would take a number of years of strong profits to generate sufficient capital to support that additional lending volume."

While traditional banks have improved their lending standards, it was the effect of debt crisis on credit markets and banking system which led to the disintegration of the shadow banking system.