Saturday, August 18, 2007

What is the Federal Reserve Discount Window?

Most people have never even heard of the Federal Reserve's "Discount Window", but on Friday it was on center stage when the FOMC cut the interest rate used for loans from the Federal Reserve Banks to banks that are made through the discount window.

There is actually an entire Fed web site dedicated to the discount window. For a little background:

When the Federal Reserve System was established in 1913, lending reserve funds through the Discount Window was intended as the principal instrument of central banking operations. Although the Window was long ago superseded by open market operations as the most important tool of monetary policy, it still plays a complementary role. The Discount Window functions as a safety valve in relieving pressures in reserve markets; extensions of credit can help relieve liquidity strains in a depository institution and in the banking system as a whole. The Window also helps ensure the basic stability of the payment system more generally by supplying liquidity during times of systemic stress.

Loans from the Fed through the discount window require collateral, which can include Treasuries, but also mortgages and even mortage-backed securities:

As always, Discount Window loans must be secured by collateral acceptable to the lending Reserve Bank.

Note: Each of the twelve regional Federal Reserve Banks does the actual lending.

The common forms of collateral include, but are not limited to:

  • Obligations of the United States Treasury
  • Obligations of U.S. government agencies and government sponsored enterprises [Fannie Mae, Freddie Mac, et al]
  • Obligations of states or political subdivisions of the U.S.
  • Collateralized mortgage obligations
  • Asset-backed securities
  • Corporate bonds
  • Money market instruments
  • Residential real estate loans
  • Commercial, industrial, or agricultural loans
  • Commercial real estate loans
  • Consumer loans

There are a number of different categories of credit offered by the Discount Window:

The primary credit program is the principal safety valve for ensuring adequate liquidity in the banking system and a backup source of short-term funds for generally sound depository institutions. Most depository institutions qualify for primary credit. Secondary credit is available to meet backup funding needs of depository institutions that do not qualify for primary credit. Seasonal credit is available to depository institutions that can demonstrate a clear pattern of recurring intra-yearly swings in funding needs.

There is in fact a fourth type of credit available through the Discount Window, Emergency Credit:

In unusual and exigent circumstances, the Board of Governors may authorize a Reserve Bank to provide emergency credit to individuals, partnerships, and corporations that are not depository institutions. Reserve Banks currently do not establish an interest rate for emergency credit, but Regulation A specifies that such a rate would be above the highest rate in effect for advances to depository institutions. Such lending may occur only when, in the judgment of the Reserve Bank, credit is not available from other sources and failure to provide credit would adversely affect the economy. When not secured by U.S. government or agency securities, loans of this type would require the affirmative vote of at least five members of the Board of Governors of the Federal Reserve System. (If fewer than five but at least two Board members are available, the available members may approve an extension of emergency credit by unanimous vote, subject to the conditions set forth in section 11(r)(2) of the Federal Reserve Act.) Emergency credit loans have not been made since the mid-1930s.

-- Jack Krupansky


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