Discount Window

The Discount Window refers to a lending facility offered by the United States central bank to assist commercial banks in managing their short-term liquidity requirement. Banks that cannot borrow funds from any other bank within the federal funds market can borrow funds directly using this facility of the central bank.

The central bank imposes a discount window interest rate on such loans. One can find the current rates on the official website of the Federal Reserve. Member banks avail of such loans to fulfill their reserve requirements every night when they close. This facility is of three types — seasonal, secondary, and primary credit.

• Discount window refers to a lending facility that the central bank of the United States provides to depository institutions to enable them to meet their reserve requirements. The Fed has been utilizing this tool for a long time to improve the financial system’s stability.
• The Fed funds rate is lower than the discount rate. Moreover, unlike the latter, the Federal Reserve does not impose the former.
• In the case of this lending facility, collaterals are valued at par. That said, The Bank Term Funding Program involves valuing collaterals at an MTM or mark-to-market basis.

Discount window refers to a monetary policy instrument enabling eligible financial institutions to get loans from the central bank of the U.S., typically on a short-term basis. This facility provided by the Federal Reserve offers liquidity to the country’s banking system and supports stability.

Borrowing through the discount window facility is usually short-term, as noted above. In most cases, such loans are overnight and collateralized. The loans are not the same as the uncollateralized lending the banks keeping deposits at the Federal Reserve engage in among themselves. The latter is offered at the federal funds rate. One must not confuse this rate with the federal discount rate. The latter is higher than the former. Also, individuals should note that the Federal Reserve sets both rates.

Banks use this facility the Fed offers when they experience shortfalls concerning short-term liquidity and require a fast cash infusion. Generally, banks prefer borrowing funds from another bank as the interest rate is lower and there is no collateral involvement. This is why borrowing funds through this facility increases when every bank is subject to liquidity pressure. Taking a loan from the Federal Reserve is simply the replacement for availing of financial assistance from another commercial bank.

Thus, if the interbank overnight lending mechanism has reached its maximum level, one views the central bank’s facility as a last resort.

The Federal Reserve also utilizes this facility in addition to the various tools available to execute monetary policy. For instance, it increases the discount rate if it intends to reduce the money supply in the economy. Simultaneously, it increases the federal funds rate. This gives the financial institutions a lower amount to offer as financial assistance, slowing down economic growth. This is known as contractionary monetary policy. The Federal Reserve uses it to minimize the effect of inflation.

Its opposite is the expansionary monetary policy, which the Fed uses to stimulate economic growth. For this, the Federal Reserve decreases the fed funds and discount rates, which increases the money supply, providing banks with additional funds to lend.

Let us look at a few discount window examples to understand the concept better.

Example #1

In April 2023, lending through the Fed’s Bank Term Funding Program or BTFB left behind the credit lines extend through the discount window of the United States central bank for the first time since the introduction of the emergency lending facility on March 12.  

According to the latest reports published by the Federal Reserve, banks borrowed funds worth $79 billion via BTFB as on April 5, marking an increase of $64 billion from the week before. The discount window of the Federal Reserve was tapped for a sum of $69.7 billion, a drop from $88 billion over that duration.

Example #2

Suppose ABC is a commercial bank in the United States. It realizes it does not have enough funds to fulfill its reserve requirements for a certain day. So, ABC borrowed funds via the Fed’s discount window. The facility allowed ABC to get funds on an emergency basis and fulfill its liquidity requirements at the time of closing on that particular day.

Let us look at a chart to understand the concept better:

Source

The above chart shows that the overall bank borrowing from the Federal Reserve’s discount window, which is a vital measure of the system’s stress, dropped significantly in the first week of May 2023. It was a signal that the panic that had begun owing to the collapse of the Silicon Valley Bank in March 2023 could be in the past.

The borrowings through the Fed’s facility where financial institutions obtain emergency cash in return for managing Fed collateral, for example, United States government bonds dropped to $5.3 billion in May’s first week, from close to $74 billion the week before.

In March, borrowing via the discount window facility had increased to $153 billion after the Silicon Valley Bank’s implosion. The plunge in discount borrowing indicates that the First Republic Bank, which was acquired by the Federal Deposit Insurance Corporation and sold for portions the previous week was the key central bank borrower.

Although one can spot gyrations in different regional bank stocks, the Federal Reserve’s data must be a relief as it does not suggest that any cash-strapped bank is rushing to the Federal Reserve for assistance.

Understanding the meaning and purpose of federal funds rate and discount rate can be challenging for individuals new to finance. One must know the distinct characteristics of these two interest rates to understand how they differ and avoid confusion. The table below shows the two rates’ critical differences.

Both the discount window and Bank Term Funding Program (BTFP) are credit facilities offered by the Federal Reserve, which often leads to the impression that they are the same. That said, one must remember that they have critical differences. Let us look at them to understand their meaning and purpose.

This has been a guide to What is a Discount Window. Here, we explain its examples, chart, and differences with the fed funds rate and BTFP. You can learn more about it from the following articles –

• Federal Open Market Committee
• Delinquency Rate
• Inverted Yield Curve