Federal Reserve Discount Window and How It Works
The Bank for Desperate Bankers
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 borrowing banks must post collateral to the Fed in return for the loan. Such collateral can include U.S. Treasury bills, bonds, and notes, state and local government securities, 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.
The Fed charges them the fed discount rate. It's 0.5 percent higher than the interest rate they charge each other for overnight borrowing, the fed funds rate. The Fed makes its rate higher because it prefers banks borrow from each other. Here's the current discount rate.
As a result, a bank avoids using the discount window as much as possible. It's a sign that there's something wrong if it can't get loans from other banks. It is seen as desperate if it is forced to pay the Fed's higher rate to get any loan at all. That makes other banks even less likely to lend to it in the future.
The Fed uses the discount window to provide a last resort for loans. It also uses the 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 usually 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. It 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. Quantitative easing is a massive expansion of open market operations. During the financial crisis, the Fed created many other innovative tools as well.
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. That's because the discount rate was lower than the Fed funds rate. Therefore, many banks avoided the discount window even if they needed it.
In January 2003, the Fed replaced that system with the primary and secondary programs. Although desperate, banks still have 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, which charges an even higher rate. 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.
There is a third program for small community banks. The Window. discount rate program can give them temporary funds if they need to make loans to farmers, students, resorts and other seasonal borrowers. There's no stigma attached to this program.
Most recently, the Fed used the discount window to pump extra liquidity into the market during the financial crisis. Banks can always rely on the discount window to supply liquidity when normal operations freeze up. But the Fed only changes the discount window in an emergency. (Source: Federal Reserve Discount Window .)