Financial Update (October-December 2001)


Cover Story

Economic Education

New MICR Standard

Credit Unions’ Risk and Membership


Did You Know?

Data Bank

The Docket

Helping Banks Meet Liquidity Needs: The Federal Reserve’s Discount Window

In the days following Sept. 11, the discount window at each Reserve Bank was a hub of activity, helping meet depository institutions’ liquidity needs and ensuring that banks were able to complete transactions. While the Federal Reserve discount window typically lends an average of tens of millions of dollars to institutions each week, during the week of the attacks, the discount window lent tens of billions of dollars.

The discount window helps the Federal Reserve fulfill a classic central bank role in times of crisis, as it did in the wake of the Sept. 11 terrorist attacks. On an ongoing basis the main role of the discount window is to serve as “the lender of last resort” to help depository institutions meet their infrequent liquidity needs. All institutions that hold reserves on their customer deposits are eligible to borrow funds at the window. This facilitates the balance sheet adjustments of individual institutions that face temporary, unforeseen changes in their asset-liability structure. The window also complements open market operations in managing the reserves market day to day and implementing longer-term monetary policy goals.

The discount window received its name during the early days of the Federal Reserve System when bankers presented collateral in the form of commercial and individual loans to their Reserve Bank’s teller window to obtain credit. Today, the discount window is a highly computerized function rather than a physical place, and its role as a macroeconomic stabilization tool is not as significant as it was. Nonetheless, the discount window is still an important tool for reserves market management, and it still plays a role in monetary policy. The discount window offers institutions three basic types of credit: adjustment credit, seasonal credit and extended credit.

While the Federal Reserve discount window typically lends an average of tens of millions of dollars to institutions each week, during the week of the attacks, the discount window lent tens of billions of dollars.

Meeting different needs
Adjustment credit helps institutions meet short-term liquidity needs caused by, for example, unexpectedly large withdrawals of deposits or operational problems. An institution can request adjustment credit through the discount window overnight or for a few days until it finds other sources of funding. Adjustment credit is provided at the Federal Reserve’s discretion. A borrower must provide an appropriate reason for the request, and the borrower must seek other sources of funds before turning to the discount window.

The seasonal credit program began in 1973 and helps smaller institutions manage liquidity needs arising from regular, intrayearly, seasonal swings in loans and deposits, such as those experienced by agricultural banks during planting season. Institutions that use this program must demonstrate a seasonal funding need that is the result of regular, four-week-long swings in deposits and loans.

Extended credit can be supplied to institutions needing credit to meet longer-term liquidity needs. Before an institution seeks extended credit, it must have made full use of reasonably available alternative sources of funding and have a plan in place for eliminating its long-term liquidity problems.

In times of national emergency, the Federal Reserve can extend emergency credit to nondepository institutions — individuals, partnerships and corporations. This type of lending may occur only when, in the judgment of the Reserve Bank, credit is not available from other sources and failure to provide credit would adversely affect the economy.

Depository institutions needing adjustment credit are generally charged the basic discount rate. The rate charged for seasonal credit is based on market interest rates and is never less than the discount rate applicable to adjustment credit. For extended credit, either the basic discount rate or a flexible rate linked to market interest rates and at least 50 basis points above the basic discount rate may be charged.

Obtaining a discount window loan
Before a depository institution borrows money from the discount window, the institution must file legal documents with the Federal Reserve. These documents outline the loan’s terms and conditions and the collateral the institution is pledging. All discount window loans are secured, and banks must have satisfactory collateral to receive a loan from the window. Any bankable asset that is investment grade or rated “pass” by regulators and legal for the bank to hold is acceptable as discount window collateral provided the Federal Reserve can perfect its security interest in the asset. For contingency purposes, institutions should have collateral pledged and borrowing agreements in place with the Fed to save time in the event that they require adjustment credit through the discount window.

Typically, the Federal Reserve credits the reserve account of an institution borrowing from the discount window. If a borrower does not have an account with the Fed, then the Fed increases the reserve account of a bank that has agreed to accept the deposits of and perform services for the borrowing institution.

Setting the discount rate
The interest rate that commercial banks and other depository institutions are charged when they receive adjustment credit from the Fed’s discount window is the discount rate. In the past, rates were maintained independently by each Reserve Bank.

Changes to the discount rate are made in times of fluctuating market conditions to complement open market operations and to support monetary policy. Directors at each Reserve Bank still determine the discount rate for their Bank subject to Board of Governors’ approval. The Board reviews requests from the boards of directors of the 12 Reserve Banks every two weeks, although it can meet between these meetings. If a recommendation by certain Federal Reserve Banks to change the rate is approved by the Federal Reserve Board, then the directors at other Reserve Banks meet, in person or by phone, and approve the change. In this way, the discount rates are quickly brought into harmony nationally.

Playing a policy role
Along with the Fed’s open market operations and reserve requirements, the discount rate is one of the three tools the Fed uses to set monetary policy. While the role of discount window lending has changed dramatically from that envisioned by the Fed’s founders, it is still an important stabilizing factor in reserves market management and in the implementation of monetary policy.

The discount window serves as a buffer in the reserves market against unexpected day-to-day fluctuations in reserves demand and supply. When demand is unexpectedly high or the supply is low, banks can turn to the window for reserves. So the availability of the window helps relieve pressures in the reserves market and reduces the extent of unexpected movements in the federal funds rate (the rate charged by an institution on an overnight loan of excess reserves to another depository). Adjustments to the discount rate can also be important in signaling shifts in the Fed’s monetary policy stance