What Is a Discount Window?
The discount window is a central bank lending facility meant to help commercial banks manage short-term liquidity needs. Banks that are unable to borrow from other banks in the federal funds market may borrow directly from the central bank's discount window paying the federal discount rate.
Key Takeaways
- The discount window is a central bank facility that offers commercial banks very short-term loans, often overnight.
- The Federal Reserve extends discount window loans to financial institutions that, in turn, support commercial industries.
- The discount window rate is higher than the federal funds target rate, which encourages banks to borrow and lend to each other and only turn to the central bank when necessary.
How a Discount Window Works
The Federal Reserveand other central banks maintain discount windows, referring to the loans they make at an administereddiscount rateto commercial banks and other deposit-taking firms.
Discount window borrowing tends to be short-term—usually overnight—and collateralized. These loans are different from the uncollateralized lending banks with deposits at central banks. In the U.S., such loans are made at the federal funds rate, which is lower than the discount rate. Even foreign banks may borrow from the Federal Reserve's discount window.
Banks borrow at the discount window when they are experiencing short-term liquidity shortfalls and need a quick cash infusion. Banks generally prefer to borrow from other banks, since the rate is cheaper and the loans do not require collateral.
The term "discount window" refers to the now obsolete practice of sending bank employees to actual physicalwindows in Federal Reserve branchlobbies to ask for loans.
For this reason, discount window borrowing tends to rise during spells of economy-wide distress, when all banks are experiencing some degree of liquidity pressure. Borrowing from the central bank is a substitute for borrowing from other commercial banks, and so it is seen as a lender of last-resort measure once theinterbankovernight lending system has been maxed out.
Example of a Discount Window
The 2008 financial crisis saw the Fed's discount window take on a central role in maintaining a semblance of financial stability. Lending periods were extended from overnight to 30 days, then 90 days. The rate was cut to within 0.25 percentage points of the federal funds rate; the spread had previously been 1 percentage point.
Special Considerations
The Fed's discount window lends at three rates; "discount rate" is shorthand for the first rate offered to the most financially sound institutions.The three rates are defined as the primary credit rate, secondary credit rate, and seasonal discount rate. All other interest rates are affected by the discount rate, including savings and money market interest rates, fixed-rate mortgages, and LIBOR rates.
According to the Federal Reserve website: "Bankers' banks, corporate credit unions, and other financial institutions are not required to maintain reserves underRegulation D, and so do not have regular access to the Discount Window. However, the Board of Governors has determined that such institutions may obtain access to the Discount Window if they voluntarily maintain reserves."
Federal Discount Rate vs. Federal Funds Rate
The federal discount rate is the interest rate the Federal Reserve charges on loans. It's not to be confused with the federal funds rate, which is the rate banks charge each other for loans that are used to hit reserve requirements. The discount rate is determined by the Federal Reserve's Board of Governors. The federal funds rate is set by theFederal Open Markets Committee(FOMC). FOMC sets the federal funds rate through the open sale and purchase of U.S. Treasuries, whereas the discount rate is reached solely through review by the board of governors.
Healthy banks are allowed to borrow all they want at very short maturities (usually overnight) from the Fed's discount window, and it is therefore referred to as a standinglending facility. The interest rate on these primary credit loans is the discount rate itself, which is typically set higher than the federal funds rate target because the central bank prefers that banks borrow from each other so that they continually monitor each other for credit risk and liquidity.
In most circ*mstances, the amount of discount lending under the primary credit facility is very small, intended only to be a backup source of liquidity for sound banks so that the federal funds rate never rises too far above its target. This theoretically puts a ceiling on the federal funds rate to equal the discount rate.
Secondary credit is given to banks that are in financial trouble and are experiencing severe liquidity problems. The central bank's interest rate on secondary credit is set at 50 basis points (or 0.5 percentage points) above the discount rate. The interest rate on these loans is set at a higher penalty rate to reflect the less-sound condition of these borrowers. Under normal circ*mstances, the discount rate sits in between the federal funds funds rate and the secondary credit rate. Example: The federal funds rate may be 1%; the discount rate 2%; and the secondary rate 2.5%.
What Is the Discount Window?
The discount window refers to lending from the Federal Reserve to banks. Such loans are done at the discount rate, which is higher than the federal funds rate. Discount window lending plays a role in maintaining liquidity and keeping the overall banking system stable.
How Does Discount Window Affect Money Supply?
The discount rate can have an effect on money supply. If the Federal Reserve lowers the discount rate, this makes it cheaper for banks to borrow money. This can effectively increase liquidity. Conversely, at higher discount rates, it's less profitable for banks to borrow money. This can lead to a decline in money in the banking system
Is a Higher Discount Rate Better?
Discount rates should be adjusted in response to specific economic circ*mstances. During periods of runaway inflation, high discount rates can help to cool the market. During periods of low economic activity, lower discount rates can stimulate spending and borrowing.
The Bottom Line
The discount window is a central bank lending facility from which banks can take out short-term, typically overnight, loans. The rate charged for these loans is higher than the federal funds rate. As such, banks are encouraged to borrow from each other and to take out loans from the Federal Reserve only as a last resort.
