Financial Update (Third Quarter 2002)


Masthead

Cover Story

Tough Credit Lesson

Accounting Reforms Not Enough

Payment Systems

Patriot Act Implementation

Financial Markets Conference

DEPARTMENTS

Data Bank

The Docket

Federal Reserve Proposes Changes to Discount Window

Changes to Discount Window
The main element of the Federal Reserve’s proposed changes is the establishment of a new type of discount window credit, termed primary credit, which would replace adjustment credit.

by Aruna Srinivasan, assistant vice president

In May the Federal Reserve Board of Governors requested public comment on a proposal to modify the credit programs offered through the Fed’s discount window. The proposal would replace the existing adjustment and extended credit programs with a pair of new programs that would issue credit at a rate above the target federal funds rate and other comparable market rates.

Today over 15,000 financial institutions, including banks, thrifts, credit unions and foreign agencies, are eligible to borrow from the discount window.

Reducing the subsidy
The major objective of the proposed change is to better align the discount window’s operations with the general money market by reducing the subsidy inherent in the below-market discount rate. Adoption of the proposal would not entail a change in the stance of monetary policy. The Federal Open Market Committee’s target for the federal funds rate would not change as a result of this proposal, and the level of market rates more generally would be unaffected.

New type of credit
The proposal’s main element is the establishment of a new type of discount window credit, termed primary credit, which would replace adjustment credit (see table). The primary credit program would complement open market operations and provide a contingency funding source for individual institutions.

By restricting eligibility to generally sound institutions and by eliminating institutions’ incentive to borrow to exploit the positive spread of money market rates over the discount rate, the primary credit program should considerably reduce the Fed’s need to review borrowers’ funding situations. As a result, institutions’ willingness to use the window when money markets tighten should increase, enhancing the effectiveness of the window as a monetary policy tool.

The proposal notes that institutions borrowing primary credit would be permitted to re-lend the proceeds in the federal funds market. Such re-lending should enhance the window’s ability to help cap money market pressures arising from temporary imbalances between the supply and demand for reserves.

Primary credit would be extended at a rate that would be above the usual level of short-term market interest rates, including the federal funds rate. Initially, the proposal recommends that the primary discount rate be established 100 basis points above the target fed funds rate.

The proposed program is broadly similar to credit mechanisms used by central banks around the world. Interest rates would be set through procedures identical to those currently in place for adjustment credit — the Reserve Banks’ boards of directors would set the primary discount rate every two weeks subject to “review and determination” by the Board of Governors. The proposal notes that public comment could help influence the choice of the initial spread and assist the Reserve Banks’ boards of directors when subsequent rates are established.

The proposal to adopt the primary credit program is also an aspect of the Fed’s ongoing contingency planning. The Fed expects to establish special procedures that would allow the System to lower discount rates in an emergency.

Adjustment Credit vs. Proposed Primary Credit
Feature Current Adjustment Credit Proposed Primary Credit
Rate Fed funds rate less 25–50 basis points Fed funds rate plus 100 basis points
Term Overnight Same
Collateral Fully covered Same
Eligibility Subjective Sound banks only
Administration Loan requests evaluated for appropriateness Minimal, market-based
Use of funds Can’t resell No restrictions

Secondary credit
Another element of the proposal would establish a secondary credit program in place of the existing extended credit program. Secondary credit would be available in appropriate circumstances to depository institutions that do not qualify for primary credit. Because such institutions are in less sound condition, secondary credit would be extended at an interest rate 50 basis points above the primary discount rate.

Comments on seasonal credit
Finally, the Federal Reserve Board is also requesting comments on the continued need for the seasonal credit program. The full discount window proposal is available on the Federal Reserve Board Web site at www.federalreserve.gov/boarddocs/press/bcreg/2002/20020517/default.htm. Comments are due by Aug. 22, 2002.