Federal Reserve Discount Window and How It Works
The Federal Reserve discount window is how the U.S. central bank lends money to its member banks. It's also called the Fed's use of credit. Banks take out these overnight loans to make sure they can meet the reserve requirement when they close each night. Since 1980, any bank, including foreign ones, can borrow at the Fed's discount window.
How It Works
The Fed offers three types of discount window lending programs to financial institutions: primary credit, secondary credit, and seasonal credit.
The Fed offers primary credit on a very short-term basis to institutions that are generally in good financial health. If an institution doesn't meet the eligibility requirements for primary credit, it can try for secondary credit, which has a slightly higher interest rate. The Fed also offers seasonal credit to smaller institutions to help them make loans to farmers, students, resorts, and other seasonal borrowers.
The borrowing banks must post collateral to the Fed in return for the loan. Such collateral can include U.S. Treasury notes and municipal government securities. It can also include AAA mortgages, consumer loans, and commercial loans. In 1999, the Federal Reserve also accepted investment-grade Certificate of Deposits and AAA-rated mortgage-backed securities.
You can find the current interest rates for the discount window lending on the Federal Reserve website. These rates are usually higher than the Fed funds target rate because it prefers that banks borrow from each other and only use the discount window as a last resort.
The Discount Window and Monetary Policy
The Fed also uses the discount window and its other tools to implement monetary policy. For example, it raises the discount rate when it wants to reduce the money supply. It raises the fed funds rate at the same time. That gives banks less money to lend, slowing economic growth. That's called contractionary monetary policy, and it's used to fight inflation.
The opposite is expansionary monetary policy, and it's used to stimulate growth. To do this, the Fed lowers the discount and Fed funds rates. That increases the money supply and gives banks more money to lend.
The Fed has many other tools that it uses to expand or constrict bank lending. Its most heavily used tool is open market operations. To expand lending, it buys the bank's securities. It replaces them with credit on a bank's balance sheet. This gives the bank more money to lend. To constrict lending, the Fed replaces the bank's cash with securities. The bank doesn't have a choice when the Fed wants to sell securities.
History of the Discount Window
When the Fed was established in 1913, the discount window was its primary tool. It provides a necessary safety valve in times of emergency. For example, during the 1999 Y2K scare and again after the 9/11 attacks, the Fed loosened its constraints to make sure banks had plenty of money.
At that time, the Fed required that banks prove they had no other source of funds. The reason was that the discount rate was lower than the Fed funds rate. Many banks avoided the discount window even when they needed it.
In January 2003, the Fed replaced that system with the primary and secondary programs. Although desperate, banks still need to have good collateral to even qualify for the primary program. If they are really in bad shape, they can only be eligible for the secondary program. But for a poorly run bank, it's still preferable than going out of business and being taken over by the Federal Deposit Insurance Corporation.
In general, banks can rely on the discount window to supply liquidity when normal operations freeze up. During the 2008 financial crisis, the Fed used the discount window to pump extra liquidity into the market.