Have you ever thought about how, every month or every week, businesses have money for paychecks? One answer is commercial paper.
It is amazing that commercial paper is central to so much economic activity and few people have even heard of it. Simply defined, commercial paper is just a short-term IOU. Any institution that needs money for a brief time period can go to its investment banker and say, “I would like to sell my commercial paper.”
So, if the Glove Company is low on revenue during the summer, instead of using its own money that it wants to keep, it can ask XYZ Bank to sell commercial paper to the bank’s clients. Now, everyone is happy. The Glove Company is pleased because it gets its payroll at an interest rate it can afford. The XYZ Bank is happy because it gets a fee for being a financial intermediary. And The Bathing Suit Company (with extra revenue), that bought the paper, is happy because it gets interest payments for a relatively secure investment.
All was okay until the commercial paper market froze during 2008. Realizing the magnitude of the crisis, the Federal Reserve stepped in and bought the paper that banks were no longer selling. On December 1, because Dodd-Frank legislation said they had to, the Fed released data on the loans they provided when the financial crisis was at it peak.
The Economic Lesson
A market is a process that enables the interaction of buyers and sellers to determine the price and quantity of a good or a service. During 2008, many financial markets stopped functioning because sellers did not want to expose their money to any risk. For the commercial paper market, many business firms needed the money to continue functioning. The Federal Reserve decided it had to intervene and provide those loans.
During 2008, the Fed, traditionally only the banker’s bank, did many things it had never done before. Some say that it temporarily became a bank for the world’s financial system. The Fed also participated in the market for commercial paper.