More on the Fed’s Discount Window Action

More on the Fed’s Discount Window Action




In making it easier for banks to
borrow from the its “discount window” the Fed is exploiting a
little-used central bank tool to calm markets, though one with
limitations in the current crisis .
The Fed’s primary means of managing interest rates and the supply of credit is through open market operations.
If it wants to increase the supply of credit and nudge interest rates
down, it buys securities, either permanently or temporarily. The money
the Fed uses to purchase the securities are eventually deposited in the
banking system and gets lent out.
The discount window is
a means for the Fed to lend directly to banks. Historically, though, it
hasn’t been used much. It was normally below the fed funds rate and
thus, to discourage banks from borrowing at the discount window and
lending it out at a profit in the fed funds market, the Fed required a
bank to prove it had exhausted all other sources of funds first.
Discount loans came to be seen, then, as the last resort of a bank in
distress and were thus avoided if at all possible. (An important
exception: discount loans shot to $46 billion after the Sept. 11, 2001
terrorist attacks disrupted the money market .)
The Fed
attempted to change this in 2003 with a new system by which the
discount rate would be set one percentage point above the fed funds
rate, and sound banks could borrow with few conditions attached. The
“changes should appreciably reduce depository institutions’ concern
that borrowing will be perceived as a sign of weakness,” Fed staffers
predicted in a description of the proposal in 2002.
In
spite of the change, discount borrowing has remained skimpy, seldom
exceeding $20 million on any given day. The high rate has deterred many
banks who can borrow more cheaply in the fed funds or other markets.
And apparently it still has stigma attached to it.
These were
the issues the Fed tried to tackle with the temporary changes announced
Friday. The rate was cut to 5.75% from 6.25%, just half instead of the
usual full percentage point above the funds rate. The term of discount
loans was extended to as much as 30 days, renewable by the borrower,
from the usual one day. These terms were meant to make discount loans a
more viable alternative to fed funds. Federal Reserve banks also can
accept a wide range of collateral for discount loans, such as subprime
mortgages as long as they’re not impaired, and triple-A rated
“private-label” mortgage backed securities. (These terms did not change
yesterday.) That’s one advantage the discount window has over the Fed’s
open market operations, in which only Treasurys, bonds issued or MBS
guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae are acceptable.
And
in an effort to eradicate the stigma, Fed officials convened a
conference call of major Wall Street institutions to announce that
“appropriate” use of the discount window would be seen as a “sign of
strength.” The Fed is trying to overcome the “collective action
problem,” i.e. the refusal by one bank to act unless all its
competitors do the same. Normally the collective action problem applies
to a reluctance to take prudential measures, like insisting hedge fund
customers supply more collateral, but it also applies to activities
with a stigma, like discount window borrowing.
Because major investment banks such as Morgan Stanley, Goldman Sachs and Merrill Lynch were
included in Friday’s call there was speculation the Fed was trying to
open the discount window to them. Fed officials emphasize the discount
window is only available to depositories (banks, thrifts, credit unions
and “industrial loan companies” or ILCs). Depositories are allowed
access to the federal safety net of the discount window and deposit
insurance only because they also submit to a panoply of federal
oversight, including capital requirements and close supervision.
Some investment banks are part of bank holding companies like Citigroup and J.P. Morgan Chase
with large bank units . Some investment banks own depositories,
primarily ILCs. But these units are small and lack the capital needed
for a significant expansion of lending. Moreover, the Fed and other
bank regulators have traditionally been careful not to let banks that
are part of larger companies become sources of funds for riskier
activities by their affiliates. Some finance companies such as Countrywide Financial that
control depositories could use the discount window to finance mortgages
that can’t be securitized in current market conditions.
Could the Fed take even more radical steps, such as opening the discount window to nondepositories such as mortgage finance companies,
which are, after all, the ones facing the strains now, not the banks?
Fed officials are not considering such a step. It would be radical,
requiring a unanimous vote of the current five sitting governors (none
of whom have shown much appetite for the sort of moral hazard such a
step entails) and of the board of directors of the reserve bank making
the loan. No such loan has been made since the 1930s, J.P. Morgan
notes.
To be sure, some of this is uncharted territory and
the Fed is likely to consult a lot with financial institutions in
coming days. But the bottom line is that by design, the discount window
is meant for banks, and they aren’t in great need of funds right now.
That is a constraint the Fed knows it must live with. Nor does it want
to get into the business of telling banks who to lend to; on Friday’s
call officials said how banks used the facility was up to them.
Ultimately it hopes either discount loans, or the knowledge of their
availability, encourages banks to finance solid borrowers, in turn
making borrowers and other firms feel more confident they can get
funding, and thus to stem the current cycle of risk aversion, flight to
quality and evaporating liquidity. If the banks don’t borrow in
meaningful size and illiquidity persists, the Fed will have to try
other tools, mostly likely an outright cut in the fed funds rate. – Greg Ip