Economics
Discount Window
The discount window is a tool used by central banks to provide short-term loans to commercial banks facing liquidity shortages. Banks can borrow funds from the central bank at a discount rate, which is typically higher than the federal funds rate. This mechanism helps to ensure the stability of the banking system and manage short-term fluctuations in the money supply.
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12 Key excerpts on "Discount Window"
- Michael Brandl(Author)
- 2016(Publication Date)
- Cengage Learning EMEA(Publisher)
Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 190 CHAPTER 2 Sample Design About Money Monetary Policy Tools: Discount Window and Term Auction Facility Another important tool of monetary policy the Fed has at its disposal is the lending of funds to depository institutions at the Discount Window. Starting in 1980, all deposi-tory institutions that have accounts with the Fed that are subject to reserve requirements can borrow funds at the Discount Window. Before 1980, only commercial banks that were members of the Federal Reserve system were allowed to borrow money at the Discount Window. Discount Window lending actually takes place at the 12 Federal Reserve banks. Before 2003, only eligible institutions who had exhausted all of their other sources of funds could borrow money at the Discount Window. Since 2003, however, the Fed may extend credit, historically on an overnight basis, to financially strong institutions with ample capital. This type of lending is referred to as primary credit . Primary credit: Healthy banks are allowed to borrow from the Federal Reserve for short periods of time, historically overnight. Each Federal Reserve bank sets the eligibility requirements for primary credit, although there is a set of criteria that is standardized throughout the Federal Reserve system. The idea behind primary credit has always been to ensure there is enough liquidity within the financial system. If, on the other hand, an individual depository institution suffers from a lack of liquidity, it can borrow funds from the Discount Window in what is called secondary credit .
- Michael Brandl(Author)
- 2020(Publication Date)
- Cengage Learning EMEA(Publisher)
Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Monetary Policy Tools: Discount Window and Term Auction Facility Another important tool of monetary policy the Fed has at its disposal is the lending of funds to depository institutions at the Discount Window. Starting in 1980, all depository institutions that have accounts with the Fed that are subject to reserve requirements can borrow funds at the Discount Window. Before 1980, only commercial banks that were members of the Federal Reserve system were allowed to borrow money at the Discount Window. Discount Window lending actually takes place at the twelve Federal Reserve banks. Before 2003, only eligible institutions that had exhausted all of their other sources of funds could bor-row money at the Discount Window. Since 2003, however, the Fed may extend credit, historically on an overnight basis, to financially strong institutions with ample capital. This type of lending is referred to as primary credit . Primary credit: Healthy banks are allowed to borrow from the Federal Reserve for short periods of time, historically overnight. Each Federal Reserve bank sets the eligibility requirements for primary credit, although there is a set of criteria that is standardized throughout the Federal Reserve system. The idea behind primary credit has always been to ensure there is enough liquidity within the financial system. If, on the other hand, an individual depository institution suffers from a lack of liquidity, it can borrow funds from the Discount Window in what is called secondary credit . Secondary credit: Banks suffering from financial difficulty can borrow from the Federal Reserve, but they must pay a penalty interest rate above the discount rate.
eBook - PDFToo Big to Fail
Policies and Practices in Government Bailouts
- Benton E. Gup(Author)
- 2003(Publication Date)
- Praeger(Publisher)
The recent Fed decision to peg the discount rate slightly above the Fed funds rate beginning on January 9 (Lagomarsino 2002) would appear to further reduce, if not eliminate, this subsidy. However, the Discount Window does provide banks with other benefits and subsidies. The Discount Window effectively offers the possibility that the Fed will extend credit to a bank that has a liquidity problem. To the extent that the window provides banks with access to loans when the private sector would not, the benefit of the Discount Window is that liquidity can be obtained at all. In that sense, the window has features of a line of credit. Also, to the extent that access to this source of credit reduces the risk that banks' liquidity prob- lems would be converted into solvency problems, the Discount Window re- duces the default risk faced by the bank's deposit and non-deposit creditors, and thus reduces the bank's cost of funds. Since this service could be provided in a manner that imposed its full, expected costs on banks, the existence of this line of credit and the better terms that it entails for banks on their other borrowing may be considered benefits to banks, and not subsidies. However, banks currently pay no fee to the Fed for this line of credit feature. Thus, the underpricing of the Discount Window services confers a safety net subsidy on banks. There are few, if any, estimates of the value of access to the discount win- dow. Along with Ely (1999), we regard the interest rate subsidy in Discount Window borrowing to be minor because, as noted above, such borrowing is 182 Too Big to Fail collateralized and the discount rate typically is not very far from risk-free rates. However, a more sizeable subsidy emanates from the Fed's providing access to liquidity when banks are least likely to be able to obtain liquidity from the private sector.
eBook - PDF- Jeffrey Yi-Lin Forrest(Author)
- 2014(Publication Date)
- CRC Press(Publisher)
However, that cannot be any further from the fact. In the process of deposit creation there are many leakages that are not considered in the development of the formula. So, if these leakages are included, a more delicate formula for the deposit creation will be established, where eliminating the requirement of deposit reserves will not lead to infinite growth in bank deposits. Additionally, because the reserves commercial banks deposited at the central bank do not bear interest, they create a high level of opportu-nity costs for the commercial banks. That means that comparing to the nonbanking financial institutions that are not required to maintain statutory reserves at the central bank, the competitiveness of commercial banks has suffered a great deal. Due to this reason, lowering or eliminating the requirement of statutory reserves has no doubt for-tified the strength the commercial banks in their market competition and maintained the stability of the banking system, while the money supply will not increase infinitely. Thirdly, let us look at the rate of discount. By altering the rate of discount, the central bank can influence the quantity of discount loans so that it can influence the amount of base money and money supply. The facility through which the central bank issues discount loans to commercial banks is known as the Discount Window. In the following, let us look at how the Discount Window works and the roles played by the central bank through the Discount Window. In terms of how the Discount Window works, the central bank generally influences the magnitude of discount loans through one of two methods. One is to alter the discount rate, the interest rate of discount loans; and the other is to apply administrative management to the Discount Window. 1 Altering the discount rate: The specifics of influence on the magnitude of discount loans by altering the discount rate are that: When the discount rate is lifted higher,
eBook - PDFIntroduction to Finance
Markets, Investments, and Financial Management
- Ronald W. Melicher, Edgar A. Norton(Authors)
- 2020(Publication Date)
- Wiley(Publisher)
The Fed sets the interest rate on these loans to banks and, thus, can influence the money supply by raising or lowering the cost of borrowing from the Fed. Higher interest rates will discourage banks from borrowing, while lower rates will encourage borrowing. Increased borrowing will allow banks to expand their assets and deposit holdings, and vice versa. Loans to depository institutions by the Reserve Banks may take two forms. One option allows the borrowing institution to receive an advance, or loan, secured by its own promissory note together with “eligible paper” it owns. In the second option, the borrower may discount – or sell to the Reserve Bank – its eligible paper, which includes securities of the U.S. government and federal agencies, promissory notes, mortgages of acceptable quality, and bankers’ acceptances. This discounting process underlies the use of the terms “Discount Window” and “discount rate policy.” The Fed’s lending rate policy was originally intended to work in the following fashion. If the Fed wanted to cool an inflationary boom, it would raise the discount rate. An increase in the discount rate would lead to a general increase in interest rates for loans, decreasing the demand for short-term borrowing for additions to inventory and accounts receivable. This, in turn, would lead to postponing the building of new production facilities and, therefore, to a decreased demand for capital goods. As a consequence, the rate of increase in income would slow down. In time, income would decrease and with it the demand for consumer goods. Holders of inventories financed by borrowed funds would liq- uidate their stocks in an already weak market. The resulting drop in prices would tend to stimulate the demand for, and reduce the supply of, goods. Thus economic balance would be restored. A reduction in the discount rate was expected to have the opposite effect.
eBook - PDF- Bruce Champ, Scott Freeman, Joseph H. Haslag(Authors)
- 2022(Publication Date)
- Cambridge University Press(Publisher)
For example, this is biweekly in the United States. If they fall short, they are faced with one of three options: (1) they can sell interest-bearing assets for fiat money; (2) they may borrow from other banks, which called the “federal funds market” in the United States; or (3) they may borrow from the monetary authority, which called the “Discount Window” by the Federal Reserve. The generally stated purpose of central bank lending is to permit banks to meet their reserve requirements when they find themselves unexpectedly short without being forced to precipitously sell off their interest-bearing assets. If the central bank approves, banks with reserves below the level required may borrow from the central bank to make up the difference. The reserves borrowed must be paid back with interest. In Chapter 13, we build a model economy in which there are temporary reserve shortages and secondary markets where assets can be traded. Indeed, one of the most interesting features of the 2007 banking crisis involves the development of special lending facilities and the necessary collateralized trades to deal with such shortages. We discuss how the Federal Reserve introduced these emergency lending facilities in our detailed discussion of the 2007 banking crisis, also in Chapter 13. Central bank lending may also be used to affect capital, output, the price level, and seigniorage even in stationary equilibria. While the Discount Window is considered a separate tool, we present the loans by the central bank as a means to alter the effective reserve requirement faced by banks. In this section, we examine this role of central bank lending. With its control over the stock of fiat money, a central bank has no trouble lending to a private bank: It simply prints whatever amount it wishes to lend and gives it to the private bank in return for the bank’s promise to repay the loan, possibly with 10.4 Central Bank Lending 191 interest, at a later date.
- Bernard Laurens(Author)
- 2005(Publication Date)
- INTERNATIONAL MONETARY FUND(Publisher)
In the mid-1980s, the ECCB established an interbank market in an effort to assist the commercial banks in managing their liquidity and to facilitate the lending and borrowing of available reserve balances between commercial banks in a timely and cost-effective manner. The ECCB performed the role of broker and guaranteed the funds; interest rates were fixed. In October 2001, the ECCB introduced changes to the arrangements governing the interbank market. Under the new arrangement, a Bulletin Board Service, facilitated by the central bank, replaces the ECCB’s brokerage service. This service can be used by the commercial banks on a daily basis to advertise funds available for lending and to source funds for borrowing. Commercial banks negotiate on a bilateral basis for the use of excess funds in the banking system and set the terms and conditions of each loan without the intervention of the ECCB. In the conduct of interbank transactions, commercial banks can either enter into informal unsecured agreements, or can choose to enter into secured arrangements, whether by offering collateral or by repurchase agreements.The reDiscount Window for treasury bills established in 1988 under the existing country limits induces trading of government securities, thereby supporting this secondary market. Taking into account its commitment to a high foreign exchange backing ratio, the bank discounts the bills obtained under the existing credit lines to members and uses the window to build up its portfolio of domestic treasury bills. The discount rate is a policy rate which has become somewhat meaningless today. Although originally designed to influence bank lending rates and economic activity, the discount rate usually serves an announcement function, given that it has been infrequently changed and that it is not tailored to be an effective monetary instrument. Consequently, given the monetary council’s decision to set the discount rate at a higher level than the rediscount rate for treasury bills, banks are not usually interested in this use of the Discount Window.Structural Factors and Financial Market Infrastructure
The financial system of the Eastern Caribbean states has been dominated by commercial banks (Table 8.2
eBook - PDF- Kevin D. Hoover(Author)
- 2011(Publication Date)
- Cambridge University Press(Publisher)
No bank would lend reserves below that rate. As a result, the demand curve for holding reserves, which looks exactly the same as in Figure 16.2 , above the floor rate has a kink and becomes horizontal at r floor . If the total reserve supply is at a level such as R 1 , then the floor is not binding, and the analysis of the market is exactly the same as in the classic case. On the other hand, if the total reserve supply is at a point such as R 2 at which it intersects reserve demand to the right of the kink, the floor is binding, and the Federal-funds rate is determined by r floor . When the floor is binding, the new policy gives the Fed greater control over the reserve market. Whereas under the classic procedures, any fluc-tuation in the banks’ demand for reserves would change the Federal-funds rate, under the new procedures the Federal-funds rate can be targeted more exactly – it is determined by the floor. And if the Fed wishes to change the Federal-funds rate, it can do so simply by raising or lowering its target rate, which in turn changes the floor rate. Discount-Window Policy The open-market operation is far and away the most important tool of recent monetary policy. But the Fed does have other arrows in its quiver. The next in line is discount policy . The Fed can determine the discount rate , that is, the interest rate that a bank pays to borrow reserves from its district Federal Reserve Bank . The institutional mechanism through which the Fed makes discount loans is referred to as the Discount Window . Before the Great Depression, discount lending was the major source of reserves to the banking system. From the 1930s until the financial crisis of 2008–2009, discount lending was typically tiny. In the month before the onset of the recession in December of 2007, discount lending was about $366 mil-lion – less than 0.5 percent of outstanding bank reserves. For most of the post-World War II period, the Fed had set the discount rate below the Fed-funds rate.
eBook - ePub- Leonard Jay Santow(Author)
- 2016(Publication Date)
- Routledge(Publisher)
Seasonal needs are a third reason for window borrowings. Typically, such needs refer to borrowings by banks at the Discount Window to meet loans in the agricultural area. At their peak, seasonal borrowings can run as much as $400 million to $500 million on a daily basis, usually in late August and early September (less now since the rules have been changed). In periods of modest seasonal demands, such as late in the year and early in the following year, the amount can be less than $100 million. Thus, in a given week, the combination of frictional and seasonal borrowings can be as little as $100 million, or as much as $500 million. These figures do not indicate the degree of monetary tightness.A fourth reason for window borrowings is to respond to tight Fed policy. When commercial banks are strapped for funds, borrowing a sufficient amount in the funds market may be difficult irrespective of the rate. Other funding options may also prove insufficient. The weekly figure for this type of borrowing can be negligible in easy policy times, but expand by many hundreds of millions in tight policy periods.Figure 2.3 . Window Borrowings (excluding extended credit)A fifth reason window borrowings can take place is that the discount rate is low in comparison with federal funds and other money market instruments. A large rate differential tends to occur more frequently in periods of high interest rates. In recent years, the Fed has kept the discount rate relatively low and attractive to banks, compared with the funds rate. By controlling the attractiveness of the discount rate, and by encouraging or discouraging banks from using the window, the Fed can attempt to control the level of borrowings.The central bank generally frowns on unnecessary borrowing, viewing window borrowing as a privilege and not a right, and may "counsel" banks not to borrow. Quantifying the amount borrowed by banks because of rate attractiveness is impossible because banks are not supposed to borrow from the window for rate arbitrage purposes. A bank can get into difficulty with the Fed if it borrows at the window and is a net seller of funds on the same day, especially if the funds rate is high compared with the discount rate. Unpleasant consequences lie ahead for a bank that does not heed the Fed's warnings.The final reason for borrowing at the window arises when banks are experiencing considerable financial difficulty and need funds for an extended period. The term "extended credit" is used for this type of borrowing. Except for seasonal borrowings, virtually all other borrowings are overnight, over a holiday period, or over a weekend. The peak amount of extended credit was in the week ending August 29, 1984, when Continental Illinois Bank was primarily responsible for an average $7.4 billion outstanding. (Note that extended credit is excluded from Figure 2.3
eBook - PDFDomestic and Multinational Banking
The Effects of Monetary Policy
- Rae Weston(Author)
- 2019(Publication Date)
- Columbia University Press(Publisher)
In the opposite situation where open-market sales are made, it is the intention of the monetary authorities that these be reflected in the reduction of commercial bank loans and securities. However, the com-mercial banks may adjust instead by simply reducing their excess reserves or by replacing the reserves lost by borrowing additional reserves, in the US situation at the Federal Reserve's Discount Window. Of course it is up to the Federal Reserve to set the discount rate, and it may be able to make it an expensive proposition for banks to increase their reserves by raising the discount rate (although the banks may find other sources for borrowing) when they wish to reduce the money supply, and to reduce the discount rate below alternative rates for securing funds when they wish the banks to borrow to increase their reserves. It appears that if the banks elect to build up excess reserves suf-ficient to allow them to maintain a constant lending pattern regardless of cyclical variation in monetary policy, the economy, or both, they will be able to ignore discount ràte changes except so far as these on occasion may allow the banks to obtain funds more cheaply than from alternative sources. The monetary authorities may use their other tools, in particular reserve requirements, in order to lower bank holdings of excess reserves down to the level at which open-market operations will 262 Introducing Regulation into the Model of Uncontrolled Banking be of influence. Should these be insufficient, there could be implement-ation of the type of control scheme used in West Germany where all excess reserve holdings were reduced to an insignificant level and the banks had to rely on the money market, from which the Bundesbank withdrew its operations, with the result that not only bank lending but also non-bank demand for credit were reduced.
eBook - PDFFinancial Institutions
Markets and Money
- David S. Kidwell, David W. Blackwell, David A. Whidbee, Richard W. Sias(Authors)
- 2020(Publication Date)
- Wiley(Publisher)
This means that on a short‐ term basis, the Fed intervenes in the Treasury market to smooth interest rates (i.e., reduce interest rate volatility). Adjustments to the discount rate have a number of shortcomings as a tool for monetary policy. First, changes to the discount rate affect the money supply only if banks are willing to respond. Furthermore, borrowing at the Discount Window is short term, and it is difficult to gauge the impact on the money supply for a given change in the discount rate. Thus, as a practical matter, changing the discount rate is not a viable tool for conducting mone- tary policy. Changes to reserve requirements are not normally used as a tool of day‐to‐day mone- tary policy. The reason is that it is difficult to make a number of small adjustments to reserve requirements, as frequent changes are disruptive to the banking system. When the Fed does change reserve requirements, however, it is typically done to deal with a structural problem in the banking system. As noted earlier, in 2008, the Fed began paying interest on reserves deposited at the Fed. The payment of interest on required reserves was designed to reduce the implicit tax on required reserves since the banks cannot invest them in the markets. The amount of interest paid on excess reserves, however, is a monetary policy tool, and according to the Fed, the interest rate paid on excess reserves will be a primary policy tool to keep the Fed funds rate within the stated target range. Changes in this rate will have an announcement effect that will help communicate which way the Fed wishes interest rates to move.
- Daniel S. Ahearn(Author)
- 2019(Publication Date)
- Columbia University Press(Publisher)
Federal Reserve discussions of the power and place of the dis-count mechanism among the other instruments of monetary policy have been somewhat more restrained since the 1952-1953 excessive borrowing experience. The discount mechanism is now looked upon more as an aid to assuring smooth functioning of the money market than as an aggressive instrument of policy. Thus, a 1957 article by Walker, 18 then economic adviser to the president of the Federal Reserve Bank of Dallas, listed the following five advantages offered by the discount mechanism: (1) It serves best to supply temporary seasonal demands for funds for it insures quick repayment, the amounts released are assessed by those in the best position to esti-mate requirements—the borrowing banks—and the needed funds go directly to the point of pressure; (2) When the authorities are un-certain of the strength of a revival they can permit discounts to sup-ply needed funds, the build-up of borrowings serving to indicate, at the same time that it only partially satisfies, a growing strength of credit demands; (3) Discounting serves as a safety valve against excessively sharp restraint and thus permits monetary policy to be more restrictive than it might otherwise dare to be; (4) In advanc-ing discount rates, the authorities can probe market reactions by allowing the rate to go up somewhat more in one or two districts; (5) Discount rate changes are an easily understood technique of informing the market of the monetary authorities' views of the econ-omy and the credit situation. 19 These points are not cited because they are all valid, 20 but because they indicate a more modest and at the same time more realistic view of the potentialities of discounting than was taken initially by the 1 8 Walker, Discount Policy in the Light of Recent Experience, Journal of Finance, XII (May, 1957), 223-37.
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