Financial Update (Third Quarter 2002)
Federal Reserve Proposes Changes to Discount Window
by Aruna Srinivasan, assistant vice president
n 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
New type of credit
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.
Comments on seasonal credit