FEDERALRESERVE
Ready to Lend n the past, people visited their The latest attempt to address this
The Discount
Window’s Evolving I friendly neighborhood banker to
borrow money for a new house. Now,
consumers can get mortgages online.
issue was in January, when the Fed reor-
ganized the window’s operations. To
understand the significance of these
Role as a Liquidity In the early days of the Federal changes, however, they must be viewed
Reserve System, bankers visited the against the backdrop of the discount
Lifeline for friendly neighborhood discount window window’s continuing evolution.
to borrow reserves when there was a When the Federal Reserve System
Depository run on deposits or an unexpected rise was created in 1913, the discount window
in loan volume. They brought their col- was its primary instrument of monetary
Institutions lateral to a teller window at a Federal policy. By affecting the amount of
Reserve Bank. reserves held by banks, the Fed could
BY CHARLES GERENA The window doesn’t operate from influence the amount of money and
the lobby of the Richmond Fed’s down- credit available in the U.S. economy.
town office anymore. It occupies a The window provides reserves
corner of the 18th floor, where the men through two vehicles — discounts and
and women of the Loans Department advances. With the former, a bank pro-
work the phones and computers to help vides the Fed with an asset like a short-
depository institutions establish lending term business loan. In return, it
agreements and pledge collateral. receives credit equal to the asset’s value
The department’s most significant at maturity minus a “discount” based
activity isn’t processing loans, though. on the discount rate, which is the inter-
“We make a handful of loans a month est charged on the loan. When the
on average, but we have to be prepared asset matures, the Fed returns it to the
to lend to hundreds of institutions,” bank and receives a cash payment equal
says Senior Manager Gregory Robin- to the maturity value.
son. “We have to constantly monitor An advance is much simpler than a
the collateral that would secure those discount. A bank pays interest at the
loans if institutions come to us.” discount rate to receive a loan from the
Borrowers also don’t have to physi- Fed against acceptable collateral. Cur-
cally take their collateral to the Fed. rently, the window supplies all of its
They can pledge assets, such as a port- reserves in the form of advances.
folio of consumer or commercial loans, Each of the Federal Reserve’s 12
and maintain possession of them. banks could change the discount rate
Amid these and other changes, the in response to economic conditions in
mission of the discount window remains its district. When the supply of money
FRB OF MINNEAPOLIS
— to relieve liquidity strains on indi- and credit tightened, it lowered the
vidual institutions and the banking rate and made it easier for banks to
system as a whole. Over the years, the increase their reserves. When there
In the early days of the Federal Fed has tried to balance the window’s was too much money, it made it harder
Reserve, bankers visited the discount role in keeping financial markets stable for banks to boost reserves. (Today, dis-
window when they needed to borrow against the need to curtail lending that count rates across the Federal Reserve
reserves unexpectedly. may unintentionally support financially System are normally in sync.)
troubled institutions. The discount window remained the
2 Region Focus • Summer 2003
Who Knocks at the Window?
Federal Reserve’s dominant monetary itory institution wasn’t supposed to
About 460 of the Fifth District’s 1,300 depository
policy tool until the effectiveness of borrow from the window to boost its
institutions have lending agreements with the
Open Market operations emerged in normal lending capacity, or to exploit
discount window. The other 11 Federal Reserve
the 1920s. Through this tool, the Fed the spread between the discount rate
Districts combined have about the same ratio of
buys government securities to pump and the federal funds rate, which is the
institutions ready to use the window—5,500 out
money into the financial markets, or interest that institutions charge to
of 16,700.
sells securities to absorb money. Open borrow reserves from each other.
Market operations are effective only At the same time, alternative sources
800 764
I
when financial markets are broad and of credit expanded like the federal funds
FIFTH DISTRICT DEPOSITORY INSTITUTIONS
Total DIs
deep, and America’s markets had market, which Meltzer believes is more DIs with
reached that point. efficient than window borrowing 600
I
Lending
George Kaufman, director of the because reserves flow to where they are Agreements
Center for Financial and Policy most needed. Bankers also learned to 422
400
I
Studies at Loyola University, Chicago, manage their reserves better. 325
points out several advantages of Open Window volume spiked during the
Market operations. “It reduces the 1980s when reserves flowed to troubled 200
I
political pressures on [the Fed] to savings and loans, but it has generally 83 96
40 55
assist all entities in financial distress, remained low as the discount window 12
0
I
I I I I
in particular, financially weak but began to be regarded as “a lender of last Commercial Credit Savings Savings
Banks Unions Banks & Loans
politically strong entities,” he wrote resort.” Institutions have obtained
in a November 1999 paper. “The credit from other sources, including the SOURCE: Federal Reserve Bank of Richmond
private market is less likely to direct federal funds market, the nationwide
additional funds … to such entities.” Federal Home Loan Bank System, and discount window more often than
Also, “efficient markets price funds larger institutions with which they have larger ones because they have fewer
provided through Open Market opera- a correspondent relationship. funding sources with earlier cutoff
tions at the current market rate for the times for filing requests, notes Nita
particular risks involved. In contrast, ccording to the team at the Tinsley, one of the department’s senior
funds provided through the discount
window are priced administratively and,
if priced incorrectly, may both misallo-
A Richmond Fed’s discount window,
large complex banking organi-
zations in the Fifth District don’t frequent
analysts. “We are here ’til the cows
come home, or a half hour afterwards.”
(The window stays open 30 minutes
cate resources and reduce the effec- the window very often. “But when they after the close of Fedwire, which trans-
tiveness of the assistance.” come, they usually have a big need,” notes fers funds between depository institu-
As Open Market operations took Robinson. “Something has happened in tions until 6:30 p.m.)
center stage at the Fed, the discount the financial markets, and they can’t get Bad weather also accounts for some
window stepped into the sidelines in the funds that they need.” window borrowing by smaller institu-
subsequent decades. According to econ- A prominent example was Sept. 12, tions. Tinsley says that even when bank
omist Allan Meltzer at Carnegie Mellon 2001, the day after terrorists struck the employees can’t make it to work, trans-
University, the Fed discouraged banks World Trade Center and the Pentagon. actions still post to the institution’s
from window borrowing. “They took Loan volume reached $45 billion that reserve account. “Bankers don’t know
the position that borrowing was a priv- day. But there have been other what their balance is, so they’ll call to
ilege, not a right,” explains Meltzer, who instances when large banks have get the balance and borrow to cover
recently wrote a historical account of employed the window. For example, whatever is needed.”
the Federal Reserve from 1913 to 1951. ork
The Bank of New Y got a $23 billion Seasonal changes don’t drive smaller
“In the early days, they would do it by loan in 1985 when a computer glitch borrowers to the Fifth District’s dis-
restricting the kind of collateral that interrupted its transaction processing. count window as they do elsewhere.
they would take. Later …they would talk Regional and community banks Normally, seasonal credit flows from
to banks about [the potential problems usually borrow small amounts of the window into agricultural commu-
of] continuous borrowing.” reserves periodically for less dramatic nities because farmers withdraw funds
Staff at the discount window reasons, says Rebecca Snider, assistant and request loans at the beginning of
explained that credit was intended only vice president of the Loans Depart- every growing season to plant crops.
to meet unexpected shortfalls in ment. It can be late in the afternoon This can drain a bank’s deposits and
reserves on a limited basis. Also, Federal and a bank official realizes that reserves increase loan volume, explains Robin-
Reserve regulations required borrowers are running short due to human error son. But agriculture is more prominent
to exhaust all other sources of credit or an operational problem. in other regions like the Midwest.
before coming to the window. A depos- But, smaller institutions visit the Whether it’s a snowstorm or a
Summer 2003 • Region Focus 3
blackout, depository institutions of all types of securities that the Richmond In 1980, Congress allowed depository
sizes never know when a sudden short- Fed hasn’t dealt with before. institutions that weren’t members of the
fall in reserves will occur and credit Federal Reserve System to borrow from
won’t be available. That’s why Snider ast October, the Federal Reserve’s the window. But in 1991, in the aftermath
thinks they should establish access to
the discount window before something
happens. Lending agreements have
L Board of Governors approved
changes to address the issues that
have been blamed for discouraging
of the 1980s S&L crisis, lawmakers
restricted borrowing by banks that didn’t
meet minimum capital requirements.
been executed in just a few days during appropriate use of the discount window. “Discount window borrowing was pro-
emergencies, but it is generally “not a These changes went into effect Jan. 9. viding capital for banks that were basi-
quick process.” The Fed eliminated the window’s cally insolvent,” notes economist Anna
adjustment credit and extended credit Schwartz of the National Bureau of Eco-
s of January, more than three- programs. The former loaned reserves nomic Research. “That was not what the
A quarters of the Fifth District’s 422
commercial banks had lending
agreements with the window. But less than
on a short-term basis while the latter pro-
vided loans over a longer time period,
but only under exceptional circum-
Federal Reserve Act of 1913 intended the
window to be used for.”
What will be the role of the dis-
half of the region’s 96 savings banks and stances. (The seasonal credit program count window in the future? Most
only 11 percent of its 764 credit unions wasn’t changed.) economists agree that the financial
have such agreements (see graph on p. 3). Two new programs have taken their markets need a back-up source of liq-
This brings us back to an important place. Primary credit is extended for uidity during emergencies. However,
question—why don’t more institutions very short terms like adjustment others argue that the window has little
use the window? One reason has been credit, but Federal Reserve Banks must value as a monetary policy tool as long
the stigma associated with window bor- charge a discount rate that is above the as the Fed can use Open Market oper-
rowing. No one is supposed to know federal funds rate. Secondary credit for ations to influence the supply of money
about the transaction beyond the parties banks that don’t qualify for primary and credit.
involved. However, examiners from credit must be priced even higher. (In Of course, that could change if the
various regulatory agencies, including January, the discount rate for primary federal government stops its deficit
the Fed, periodically review all of the credit was 100 basis points above the spending and resumes generating sur-
loans on a bank’s balance sheet. There- Fed’s target for the federal funds rate, pluses. “If we ever ran a series of sur-
fore, bank officials have hesitated about while the rate for secondary credit was pluses and reduced the amount of
using the window too often because it 50 basis points higher than primary government debt,” says Allan Meltzer,
might serve as a red flag. credit.) Previously, adjustment credit this might leave fewer government secu-
Also, the banking industry can often was priced at the discount rate, which rities for the Fed to buy and sell in its
tell when someone borrows from the has been consistently lower than the Open Market operations. “There would
window, which can raise questions about federal funds rate since 1990. have to be another mechanism.” RF
the institution’s financial strength. “If a Pricing window credit above the
large institution is in the marketplace market rate is intended to create an
READINGS
looking for a large volume of money and economic disincentive for excessive
Kaufman, George G. Do Lender of Last
all of a sudden it drops out, there is an borrowing, which is how many central
Resort Operations Require Bank
assumption that it went to the window, banks operate their discount windows.
Regulation? Chicago: Center for
especially if within that district there This will substitute for what George Financial and Policy Studies, Loyola
was a large amount of borrowing Kaufman calls the Fed’s “gentle per- University, Chicago, November 1999.
reported for that week,” says Snider. suasion” and scrutiny of borrowers.
.,
McKinney, George W Jr. The Federal
Another reason why depository Fewer questions, if any, will be asked Reserve Discount Window: Administration
institutions have been reluctant to when a borrower comes to the discount in the Fifth District. New Brunswick, N.J.:
borrow from the discount window is window. Any financially sound institu- Rutgers University Press, 1960.
the time and effort involved with the tion can obtain credit for any purpose. Meltzer, Allan H. A History of the
application process. Also, it may take Also, borrowers are not required to Federal Reserve. Chicago: University of
time for window staff to assess the bor- exhaust all market sources before uti- Chicago Press, 2003.
rower’s collateral. Some forms of col- lizing the window. Schwartz, Anna J. “The Misuse of the
lateral are straightforward to evaluate, The Board of Governors also Fed’s Discount Window.” Federal
such as U.S. Treasury and agency secu- approved these changes to address the Reserve Bank of St. Louis Review,
rities, and investment-grade debt issued perception that banks resort to window September/October 1992, pp. 58-69.
by state and local governments. But borrowing only when they are in finan- Visit www.rich.frb.org/pubs/
consumer and commercial loans can cial trouble. Plus, it wanted to make regionfocus for links to relevant sites.
take longer to review, as well as new borrowing administratively easier.
4 Region Focus • Summer 2003