The Federal Reserve is attempting to reposition the primary credit facility as a source of daily liquidity, almost a century after it initially attempted to prevent regular borrowing from its traditional backstop program, known as the discount window, by central bank officials.
Washington policymakers hope to alter that. Carl Carlson, co-president and chief financial officer, stated, “There’s definitely a stigma.” “If you have to use the safety net, you needed something and missed a rung on the swing.”
Following the failure of Silicon Valley Bank and other regional lenders in the first half of 2023, the task has taken on greater urgency. Regulators were taken aback by the quick flight of deposits, but they were also taken aback by the fact that SVB and other institutions were ill-equipped to take advantage of the discount window, and had to rely largely on borrowings from Federal Home Loan Banks, which might increase funding costs for everybody.
In a speech on December 1, Federal Reserve Vice Chair for Supervision Michael Barr stated, “Banks need to be ready and willing to use the discount window in good times and bad.”
The senator from Virginia, Mark Warner, has stated that he is considering legislation that would require US banks to use the facility. Furthermore, the massive overhaul proposal for the FHLB system by the Federal Housing Finance Agency, which was unveiled in November, aims to push banks to engage in more discount window business during times of crisis.
Although there have been prior attempts to redesign the window, success will need support from all facets of the financial system and those in charge of it, including banks, supervisors, analysts, rating agencies, and market players who have long looked the establishment with distrust.
Early in the Fed’s existence, banks frequently turned to the central bank for “rediscounting,” a procedure that let them convert dollars into private debt like commercial paper.
This began to alter in the late 1920s when politicians began to frown upon the practice and mandated that banks demonstrate that they had exhausted all private funding options and had a good justification for borrowing money. This gave rise to the myth that anyone using the discount window had to be having problems, a reputation that has followed the Fed ever since.
To encourage banks to borrow during recent stressful times, the Fed has established short-term lending programs. One such program is the Bank Term Funding Program, which was introduced amid the regional bank crisis last year. The Fed announced on January 17th that it was raising the interest rate on loans made under the program in advance of its March 11 expiration, following a spike in borrowing in recent weeks. Banks were delighted to take advantage of the program’s favorable terms.
In a statement announcing the move, the Fed stated that banks “will continue to have ready access to the discount window to meet liquidity needs.”
When the central bank created the principal credit facility in 2003, it completely redesigned the discount window. Now, only well-capitalized institutions are authorized to borrow at interest rates higher than the federal funds rate set by the Fed, and they are not required to demonstrate their need for the loans. Additionally, it established a backup credit line for smaller organizations.
The stigma associated with using the facility has remained, despite these modifications, according to Susan McLaughlin, a 30-year New York Fed veteran who handled discount window operations throughout the financial crisis.
Part of the problem, according to McLaughlin, who retired in August, was contradictory advice from the Fed and other authorities over when banks should use the facility for funding.
She said that bankers had repeatedly stated that they would not come to the window, even if the central bank had encouraged them to, since they were being questioned by senior management, internal risk committees, or supervisors who remembered a time when using the facility for borrowing was not recommended.
Additionally, McLaughlin stated that even with a two-year lag, banks consistently signaled during her tenure at the Fed that additional disclosure rules under the Dodd-Frank Act were a possible disincentive.
The US must determine the purpose of the discount window and take appropriate action to provide the necessary incentives to make sure it works, according to McLaughlin, who is currently an executive fellow at Yale University’s Program on Financial Stability.
She suggested that supervisory practices be more closely aligned by regulators to reaffirm that the discount window is a valid source of short-term liquidity when required, facilitate bank applications for access, and allow firms to transfer collateral at night if necessary to support Fed borrowings.
Some have suggested that the Fed should forgo reforms entirely and instead enhance its Standing Repo Facility, which allows institutions to borrow money at a rate that is also in line with the upper bound of the central bank’s policy goal range in exchange for Treasury and agency debt. Of the thousands of banks in the US, there are currently only roughly 26 counterparties in addition to the principal dealers.
As a former financial analyst at the New York Fed in the 1980s, Christopher Whalen, head of Whalen Global Advisors, a financial consulting firm, stated, “They’re going to have to be very, very focused on making sure its competitive.”
But according to McLaughlin, there is still time to rethink the discount window’s structure and make it a more useful tool for preventing short-term funding hiccups at a bank that is otherwise in good standing from becoming solvency issues.
“In the last fifteen years, there have been three stressful episodes,” she stated. “We should be scrutinizing our lender of last resort toolkit more closely.”
