Discount Window Lending
Federal Reserve Banks lend funds to depository institutions through discount window programs. All depository institutions that maintain transaction accounts or non-personal time deposits subject to reserve requirements are eligible for discount window programs. These include commercial banks, thrift institutions, and U.S. branches and agencies of foreign banks. Prior to the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980, discount window borrowing generally had been restricted to commercial banks that were members of the Federal Reserve System.
Reserve Banks have three traditional lending programs for depository institutions—primary credit, secondary credit and seasonal credit programs.
Reserve Banks extend primary credit on a short-term basis (typically overnight) to depository institutions with strong financial positions and ample capital, at a rate above the target federal funds rate. Under the administration of the discount window revised January 9, 2003, an eligible institution need not exhaust other sources of funds before coming to the discount window, nor are there restrictions on the purposes for which the borrower can use primary credit.
Reserve Banks generally determine eligibility for primary credit according to a set of criteria that is uniform throughout the Federal Reserve System, based mainly on the borrower's examination ratings and capital levels. Supplementary information, including market-based information when available, also could be used to determine eligibility. Primary credit ordinarily is extended with minimal administrative burden on the borrower. See the discount window link on the right for rate details.
Reserve Banks offer secondary credit to institutions that do not qualify for primary credit. As with primary credit, secondary credit is available as a backup source of liquidity on a short-term basis, provided that the loan is consistent with a timely return to a reliance on market sources of funds. Longer-term secondary credit may be available, if necessary, for the orderly resolution of a troubled institution. Unlike the primary credit program, secondary credit does not necessarily allow for a minimal administrative burden because Reserve Banks need to obtain sufficient information about a borrower's financial situation to ensure that an extension of credit complies with the conditions of the program.
The Reserve Banks offer seasonal credit to small- and mid-sized depository institutions able to demonstrate a clear pattern of recurring intra-year fluctuations in funding needs. Primary users of seasonal credit are small depository institutions in agricultural communities. Resort-area banks are another, though less significant, user of seasonal credit. An interest rate that varies with the level of short-term market interest rates is applied to seasonal credit.
Discount window loans must be secured by collateral with value that at least equals the amount of the loans. A wide range of assets are acceptable as collateral. In 1999, the Federal Reserve expanded the range of acceptable collateral to include such items as investment-grade certificates of deposit and AAA-rated commercial mortgage-backed securities. Other acceptable collateral consists of U.S. Treasury securities, state and local government securities, collateralized mortgage obligations (AAA), consumer loans, commercial and agricultural loans and certain mortgage notes on one-to-four-family residences. See Federal Reserve Discount Window and Payment System Risk Collateral Margins Table.
The Fed monitors borrowing by undercapitalized institutions to ensure compliance with the Federal Deposit Insurance Corporation (FDIC) Improvement Act of 1991, which stipulates that the Fed may not lend to a critically undercapitalized institution for more than five days beyond the date on which it became critically undercapitalized without incurring a potential liability to the FDIC.
Before the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) was signed into law on July 21, 2010, under unusual and exigent circumstances, a Reserve Bank had legal authority to advance credit to individuals, partnerships and corporations that are not depository institutions, after consultation with the Board of Governors of the Federal Reserve System. To do so, the Reserve Bank must have determined that credit was not available from other sources and that failure to provide the credit would have adversely affected the economy. After last being used in the 1930s, emergency credit, authorized under section 13(3) of the Federal Reserve Act, was initiated in response to the recent financial crisis as several special emergency credit facilities were created in 2008 and 2009.
The Dodd-Frank Act changes the Federal Reserve’s authority for lending under unusual and exigent circumstances. Reserve Banks can no longer extend credit to an individual, partnership, or corporation other than through a “program with broad-based eligibility.” Such emergency facilities can only be created with prior approval of the Treasury Secretary and must be for the purposes of providing liquidity to the financial system and not to aid a failing financial company.
History of Discount Window Lending
Prior to January 2003, the discount window lending consisted of adjustment credit, extended credit and seasonal credit programs.
Customarily, the interest rate on adjustment credit was less than the federal funds rate, usually by 25 to 50 basis points during the 1990s. The below-market rate for adjustment credit created incentives for an institution to borrow at the discount window. However, regulation required institutions to first exhaust other available sources of funds and explain their need for adjustment credit. The administration of adjustment credit by Reserve Banks may have created uncertainty among some depository institutions about their access to discount window credit.
Institutions that borrowed at the discount window sometimes expressed concern that borrowing at the window signaled weakness both to competitors and the Fed. Such concerns deterred some depository institutions from borrowing at the discount window during times of very tight conditions in money markets when doing so would have been appropriate. This, in turn, hampered the ability of the discount window to buffer shocks to the money markets.
To address some banks' reluctance to borrow and other concerns, the Federal Reserve Board replaced the existing adjustment and extended credit programs with primary and secondary credit programs, beginning January 2003, while retaining the seasonal lending facility.
The passage of the Dodd-Frank Act in July 2010 requires the disclosure of details of loans made under traditional discount window programs on a two year lag from the date on which the loan is made. The details of loans made under the Fed’s emergency credit programs were released on December 1, 2010.
The term "discount rate" usually is applied to the interest rate on primary credit available from the Federal Reserve. Under the program enacted in 2003, Reserve Banks establish the primary credit rate at least every 14 days, subject to review and determination of the Board of Governors. Reserve Banks may recommend adjustments in the rate on primary and secondary credit at their discretion, subject to the approval of the Board of Governors. The revised program includes terms to facilitate a reduction in the primary credit rate in a financial emergency.
Changes in discount window policy occurred several times in recent years. For example, the Fed liberalized discount window policy in anticipation of possible Y2K-related liquidity strains in the economy. From October 1, 1999, through April 7, 2000, it established a special liquidity facility that borrowers could use without having to first seek credit elsewhere.
Following the attacks on the Pentagon and World Trade Center in September 2001, the Fed again encouraged depository institutions needing liquidity to borrow from the discount window.
During the financial crisis that began in the summer of 2007, several adjustments were made to encourage institutions to borrow from the discount window including extending the maximum term on primary credit loans to 30 days in August 2007 and then to 90 days in March 2008. As of March 2010, the maximum term on discount window loans has been reduced back to typically overnight. Also, the spread between the primary credit rate and the target fed funds rate was reduced from 100 basis points to 50 basis points in August 2007 and to 25 basis points in March 2008. In February 2010, the spread was widened back to 50 basis points.
By employing an above-market rate and restricting eligibility to generally sound institutions, the primary credit program aims to considerably reduce the need for the Federal Reserve to review the funding situations of borrowers and monitor the use of borrowed funds. This reduced administration, in turn, strives to make the discount window a more attractive funding source for depository institutions when money markets tighten.
Prior to 2003, the discount rate's importance as a tool of monetary policy was limited, because banks did little adjustment credit borrowing at the discount window. The effectiveness of the revised discount window lending program as a tool of monetary policy is assessed on an ongoing basis.