Recent developments in discount window policy - includes related articles on the borrowing behavior of large banks, changes in the borrowing function and the Federal Deposit Insurance Corporation Improvement Act of 1991

Federal Reserve Bulletin, Nov, 1994 by James A. Clouse

Underlying trends in the depository sector along with changes in federal legislation have had important ramifications in recent years for the discount window, the Federal Reserve's lending facility. The periods of stress and consolidation in the depository sector during the 1980s and 1990s led to the active involvement of the discount window in many failing-bank situations. Indeed, the scope of problems in the banking industry and the extent of discount window lending to troubled institutions were greater than in any period since the Great Depression.

In addition, changes became evident during the 1980s in the wilingness of healthy institutions to turn to the discount window. Many banks apparently became more reluctant to turn to the window for fear of provoking market concerns about their financial condition. The greater reluctance to borrow weakened the historical relationship between discount window borrowing and the spread of the federal funds rate over the discount rate. This weakening, in turn, impaired the effectiveness of the discount window in tempering unexpected pressure in the reserve market and reduced the Federal Reserve's emphasis on borrowed reserves in the day-to-day management of the reserve market.

Perhaps the most notable legislation affecting the discount window has been the Depository Institutions Deregulation and Monetary Control Act of 1980, which dramatically expanded the universe of depository institutions eligible to borrow at the discount window. As a result, the Federal Reserve assumed greater direct responsibility for responding to the liquidity needs of all depositories.

Another important legislative change arose in response to the large number of bank failures in the 1980s and the associated depletion of the insurance funds of the Federal Deposit Insurance Corporation (FDIC). The legislation, the Federal Deposit Insurance Corporation Improvement Act of 1991, contained provisions intended to discourage Federal Reserve lending to depositories that do not meet minimum capital standards. Although these provisions do not prohibit the Federal Reserve from lending to such institutions, they specify that the Federal Reserve will incur a limited liability to the FDIC for lending that extends beyond certain time periods and that results in increased losses to the FDIC's insurance funds.

DISCOUNT WINDOW LENDING: THE BASICS

Sections 10B and 13 of the Federal Reserve Act authorize the Federal Reserve Banks to extend discount window credit to depository institutions in the form of discounts and advances. In the early years of the Federal Reserve System, discounts were the primary form of discount window credit. A bank wishing to obtain a discount from its Federal Reserve Bank would present a short-term business loan or other asset meeting the type and maturity specifications set forth in the Federal Reserve Act. The Federal Reserve Bank would extend credit in an amount that reflected the value of the asset at maturity minus a "discount" based on the Federal Reserve's discount rate and the time until maturity of the asset. When the asset matured, the Federal Reserve returned it to the bank and received from the bank a cash payment equal to the maturity value of the asset.

An advance is operationally simpler than a discount, and all discount window credit has been provided in the form of advances for many years. For an advance, a bank requests a loan from its Federal Reserve Bank. The rate charged on the loan is the discount rate, and the duration of the loan is determined by the Reserve Bank.(1) To secure the advance, the borrower must pledge collateral in amounts and of types that are satisfactory to the lending Reserve Bank.

In addition to authorizing loans to "eligible" depository institutions, the Federal Reserve Act--in sections 13(3) and 13(13)--authorizes the System to act in emergency circumstances as "lender of last resort" to individuals, partnerships, and corporations. Enacted in 1932, section 13(3) was intended to enable the Federal Reserve to provide credit in the form of discounts for borrowers unable to obtain adequate credit accommodations from other banking institutions; its use was limited to periods of unusual and exigent circumstances, as determined by the affirmative vote of at least five members of the Board of Governors.(2)

The Congress enacted section 13(13) in 1933 to authorize the Federal Reserve to make advances to individuals, partnerships, and corporations on the security of U.S. Treasury and federal agency obligations. Although this provision, unlike section 13(3), carries no statutory restrictions on its use, the Federal Reserve has always regarded its applicability as being limited to unusual or exceptional circumstances. Indeed, since 1973, the Board's Regulation A, which governs discount window lending activities, has restricted use of this authority to emergency circumstances in which borrowers cannot obtain credit from other sources and their failure to obtain credit would adversely affect the economy.