Discount Window

What Is a Discount Window?

The discount window is a central bank lending facility intended to assist commercial banks with overseeing short-term liquidity needs. Banks that can't borrow from different banks in the fed funds market might borrow straightforwardly from the central bank's discount window paying the federal discount rate.

Current discount rates are listed on the Federal Reserve's website.

How a Discount Window Works

The Federal Reserve and other central banks keep up with discount windows, alluding to the loans they make at a regulated discount rate to commercial banks and other store taking firms.

Discount window borrowing will in general be short-term — typically overnight — and collateralized. These loans are unique in relation to the uncollateralized lending banks with deposits at central banks do among themselves; in the U.S. these loans are made at the federal funds rate, which is lower than the discount rate. Even foreign banks might borrow from the Federal Reserve's discount window.

Banks borrow at the discount window when they are encountering short-term liquidity shortfalls and need a quick cash imbuement. Banks generally really like to borrow from different banks, since the rate is less expensive and the loans don't need collateral.

The term alludes to the now obsolete practice of sending bank employees to actual, actual windows in Federal Reserve branch entryways to ask for loans.

Thus, discount window borrowing will in general rise during spells of extensive distress, when all banks are encountering some degree of liquidity pressure. Borrowing from the central bank is a substitute for borrowing from other commercial banks, thus it is viewed as a lender of last-resort measure once the interbank overnight lending system has been pushed to the limit. The Federal Reserve sets this interbank rate, called the Fed funds rate, which is generally set lower than the discount rate.

Illustration of a Discount Window

The 2008 financial crisis saw the Fed's discount window take on a central job in keeping a similarity to financial stability. Lending periods were extended from overnight to 30 days, then 90. The rate was cut to inside 0.25 percentage points of the federal funds rate; the spread had recently been 1 pp, and as of November 2017, it is 0.5 pp.

Special Considerations

The Fed's discount window loans at three rates; "discount rate" is shorthand for the top notch offered to the most financially sound institutions. The three rates are defined as the primary credit rate, secondary credit rate, and seasonal discount rate. Any remaining interest rates are impacted by the discount rate including savings and money market interest rates, fixed-rate mortgages, and LIBOR rates.

As indicated by the Federal Reserve website:

"Bankers' banks, corporate credit unions, and other financial institutions are not required to keep up with reserves under Regulation D, thus don't have customary access to the Discount Window. In any case, the Board of Governors has determined that such institutions might get access to the Discount Window assuming they willfully keep up with reserves."

Federal Discount Rate versus Federal Funds Rate

The federal discount rate is the interest rate the Federal Reserve charges on loans from the Federal Reserve. In no way related to the federal funds rate, which is the rate banks charge each other for loans that are utilized to hit reserve requirements. The discount rate is determined by the Federal Reserve's board of governors, rather than the federal funds rate, which is set by the Federal Open Markets Committee (FOMC). The FOMC sets the Fed funds rate through the open sale and purchase of U.S. Treasuries, while the discount rate is arrived at exclusively through survey by the board of governors.

Sound banks are permitted to borrow all they need at exceptionally short maturities (typically overnight) from the Fed's discount window, and it is thusly alluded to as a standing lending facility. The interest rate on these primary credit loans is the discount rate itself, which is normally set higher than the federal funds rate target, in light of the fact that the central bank lean towards that banks borrow from one another so they persistently monitor each other for credit risk and liquidity.

Subsequently, by and large the amount of discount lending under the primary credit facility is tiny, expected exclusively to be a backup source of liquidity for sound banks so the federal funds rate never rises too far over its target — it hypothetically puts a ceiling on the Fed funds rate to rise to the discount rate.

Secondary credit is given to banks that are in financial difficulty and are encountering serious liquidity issues. The central bank's interest rate on secondary credit is set at 50 basis points (0.5 percentage points) over the discount rate. The interest rate on these loans is set at a higher penalty rate to mirror the less-sound condition of these borrowers. Under normal conditions, the discount rate in the middle of between the Fed Funds rate and the secondary credit rate. Model: Fed funds rate = 1%; discount rate = 2%, secondary rate = 2.5%.

Features

• The discount window is a central bank facility that offers commercial banks exceptionally short-term loans (frequently overnight).
• The discount window is additionally utilized for central banks when they act as lenders of last resort.
• The Federal Reserve stretches out discount window loans to financial institutions that, thusly, support commercial industries.
• The discount window rate is higher than the fed funds target rate, which urges banks to borrow and loan to one another and possibly go to the central bank when essential.