What Is A Discount Window?
The discount window is the mechanism through which central banks lend short-term money to the commercial banks under their authority, both to provide liquidity to the financial system and to manage their monetary policies.
In the U.S., commercial banks—both based in the country and foreign-based—can borrow from the discount window at the 12 regional Federal Reserve Banks located around the country. Each of the 12 banks charges the same interest rates.
The Fed has three main types of credit through its discount window.
- Primary credit is the "principal safety valve" for ensuring liquidity in the system and is available to banks that are in "generally sound financial condition."
- Secondary credit is available for banks that aren't eligible for primary credit to meet their "backup liquidity" needs, not to increase their asset base. These loans are very short-term, usually overnight, and require a higher level of oversight by the regional Fed bank.
- Seasonal credit is available to smaller banks—those under US$500 million in assets—that have liquidity pressures due to the seasonality of the businesses they lend to, such as construction, farming and resorts. These loans can be as long as nine months in maturity.
Although all three types of credit require borrower banks to post collateral at least equal to the amount of the loan, secondary credit normally carries a higher interest rate and a bigger "haircut" than primary credit. A bigger haircut requires the borrower to post higher quality and more liquid assets as security for the loan. Eligible collateral generally includes government securities, highly-rated mortgage-backed securities, municipal bonds, certificate of deposits and commercial and consumer loans.
The Fed had previously charged a higher interest rate on secondary credit. However, in response to the coronavirus pandemic and effective 16 March 2020, it reduced the spread between the two types of credit. It also extended the maturity of such loans from overnight to as long as 90 days, renewable by the borrower on a daily basis.
The Fed also uses the discount window to implement its monetary policy. For example, if it wants to encourage banks to lend more money to businesses and consumers in order to stimulate economic growth and job creation, it will lower the discount rate. Conversely, if it believes the economy is in danger of overheating and risks igniting inflation, it will raise the rate.
What Is The Discount Window "Stigma"?
Although borrowing from the discount window for very short periods seems rather innocuous, banks in the U.S. historically have been reluctant to borrow from it because of the "stigma" attached to doing so. There is a perception that it signals to competitors, the financial markets, the public and the Fed itself that the bank is in financial trouble and may be poised to dump assets. This reluctance to use the discount window in turn makes the Fed's job more difficult to help calm anxious financial markets and implement its monetary policy, potentially exacerbating the situation.
To try to encourage lending through the discount window, the Fed has at various times of market stress and liquidity constraints taken steps to liberalise its policies, such as in the runup to and immediate aftermath of the dotcom bubble in 2000, the 2001 terrorist attacks, the 2008 global financial crisis and the 2020 coronavirus pandemic. The 2010 Dodd-Frank Act requires the Fed to wait two years before it can disclose the identity of banks that borrow through the window.
In addition to lowering the rate and lengthening the maturity of discount window loans during the 2020 pandemic, the Fed said it would stop disclosing discount window activity at the regional Fed banks and instead only show a national total.
Following the Fed's moves in 2020, eight of the largest banks in the U.S. that comprise the Financial Services Forum—they include JPMorgan Chase, Bank of America, Wells Fargo and Citigroup—said they would start borrowing from the window in order to encourage other banks to follow. In 2008 the Fed "arm-twisted" banks to use the window, although that proved effective only for a short while before it changed its policies.
The discount window is a short-term lending program in which central banks make loans to private banks under their oversight in order to ease liquidity constraints in the financial markets and to implement their monetary policy. In the U.S., at least, there has been a long-time "stigma" associated with banks borrowing through the window because of the perception that the institution is in financial trouble. During various financial crises, central banks have adjusted their discount window policies in order to encourage its use.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…