By changing how it operates the discount window, the Fed aims to provide banks with a less burdensome source of short-term funding and to encourage commercial banks to occasionally use the Fed as a source of short-term funds.Discount window

Craig Furfine

English

Research Papers in Economics

Chicago Fed Letter
Discount window borrowing: Understanding recent experience
by Craig Furfine, senior economist and economic advisor
By changing how it operates the discount window, the Fed aims to provide banks with a
less burdensome source of short-term funding and to encourage commercial banks to
occasionally use the Fed as a source of short-term funds.
ESSAYS ON ISSUES THE FEDERAL RESERVE BANK MARCH  2005
OF CHICAGO NUMBER 212
1. Borrowing from the Fed
SOURCE: Federal Reserve H.3.
Borrowed reserves
Share of required reserves
that are borrowed
$ millions
On January 9, 2003, the Federal Reserve
made two changes to the operation of
the discount window, which allows banks
to borrow from the Fed. These changes
were aimed at providing banks with a
less burdensome source of short-term
funding.
First, the Fed relaxed
many restrictions, so
that banks in good
health with adequate
collateral no longer
need to seek alterna-
tive sources of funds
before coming to the
discount window, nor
do they generally
need to provide a rea-
son for their desire to
borrow. Second, the
Fed set the rates it
charges on primary
and secondary bor-
rowing at 100 basis
points and 150 basis
points, respectively,
over the Fed’s target
for the federal funds
(interbank) rate.1 Previously, the Fed
had offered short-term loans to banks
at below-market rates of interest. Tak-
en together, these changes imply that
banks willing to pay the higher explic-
it cost of borrowing from the Fed will
be able to do so without being subject
to much central bank scrutiny. Although
the Fed has always offered a lending
service, this recent change to discount
window administration reflects, in part,
an attempt to encourage commercial
banks to use the Fed as a source of
short-term funds. In this Chicago Fed
Letter, I review the reasons banks may
wish to borrow from the central bank,
the historical data related to such bor-
rowing, and the actual level of borrowing
since these administrative changes.
Why borrow from the Fed?
The discussion here relates to the use
of the discount window as a source of
last-minute, short-term liquidity for fi-
nancial institutions that are not finan-
cially troubled.2 For these institutions,
the discount window may be a useful
source of short-term funding in three
circumstances. First, discount window
loans may be attractive if they are avail-
able at a rate below what is available in
the market. Second, discount window
loans may provide last-minute funding
to banks that unexpectedly find them-
selves deficient in satisfying their reserve
requirements. Third, should unexpect-
ed payment outflows affect a bank’s
reserve account late during a business
day, discount window credit can be
used to avoid an overnight overdraft.
Historical use and need for change
It is important to realize that the pri-
mary motivation for borrowing has
changed over time. During the 1970s
and 1980s, the discount rate was typi-
cally below the rate that banks faced
in the federal funds market. As a re-
sult, supervisory scrutiny and central
bank moral suasion were needed to
limit the market’s use of such loans.
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
0.00
0.05
0.10
0.15
0.20
0.25
1975 ’77 ’79 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 2001 ’03
share3. Borrowing and required reserve balances
SOURCE: Federal Reserve H.3.
2. Summary statistics
Average share Average
Total Average share of required absolute funds Average
borrowed of required reserve rate deviation required
reserves reserves balances (percentage reserve balance
(in $ millions) borrowed borrowed points) turnover
1975–90 1,182.438849 0.027006668 0.045135045
1975–90 1,011.750623 0.022234971 0.035648945
without
Continental
Illinois (5/16
–12/19,1984)
1991–96 233.0255591 0.004363043 0.011324851
1997–2002 261.658147 0.006498482 0.039656679 0.095559821 321.8599
1997–2002 216.6699346 0.005299486 0.031624504 0.089825581
without 9/11
and Y2K
2003–present 113.0454545 0.002647286 0.010946472 0.051428571 286.4411
SOURCE: Author's calculations based on Federal Reserve H.3 and H.15.
In other words, the total costs of bor-
rowing from the Fed were greater than
the explicit cost of the discount rate,
and these non-price terms served to
ration the amount of credit provided
by the Fed. Nevertheless, banks did in-
crease their borrowing from the Fed
when the spread between the federal
funds rate and the discount rate in-
creased.3 Between 1975 and 1990, banks
typically borrowed over $1 billion a day
from the Fed.
During the early 1990s, however, bor-
rowing from the discount window fell
significantly, averaging only $233 mil-
lion, even though this was a period of
banking system stress (see figure 1).
Peristiani (1998) argues that this decline
may have been due to banks refraining
from requesting discount loans because
of the perception that it would send a
negative signal to the Federal Reserve,
bank supervisors, and eventually the
market at large.4 Even when banks’ fi-
nancial conditions improved in the
mid-1990s, banks remained reluctant
to borrow from the Fed.
Partly to address this reluctance, the Fed
replaced its adjustment and extended
credit programs with the new primary
and secondary credit facilities. Now,
banks in good financial condition5
could borrow from the Federal Reserve
at 100 basis points above the target
federal funds rate.6 The above-market
price of funds serves as a rationing
mechanism that dramatically reduces
the need for supervisory review of the
potential borrower. Because use of the
new primary credit facility would not
necessarily imply anything negative
about a borrower, banks should be
more willing to use the facility if market
or bank-specific conditions warrant.
In fact, since the implementation of
this new facility, banking supervisors
have specifically announced that “oc-
casional use of primary credit for short-
term contingency funding should be
viewed as appropriate and unexcep-
tional by both [bank] management
and supervisors.”7
As evident in figure 1, however, aggre-
gate borrowing from the Fed seems to
have changed little from the 1990s.
This is consistent with the evidence
presented in Furfine (2003), which
suggests that during the first three
months of the new facility’s operation,
some banks were willing to pay more
than 100 basis points above the target
funds rate to a coun-
terparty in the federal
funds market rather
than borrow at better
terms from the Fed’s
primary credit facility.8
Thus, the early evi-
dence suggests a con-
tinued reluctance to
borrow.
Discount window
borrowing and
reserve requirements
When a bank borrows
from the Fed, it in-
creases the funds it
has in its reserve ac-
count held at the
Fed, which the bank can apply towards
meeting its reserve requirement. Thus,
all else being equal, one would expect
that when required reserves are higher,
discount window borrowing would be
higher. Figure 1 also plots discount
window borrowing as a fraction of re-
quired reserves. There are no obvious
differences between the two lines in
figure 1 except for scale, suggesting
that even relative to required reserves,
discount window borrowing has been
low since 1990. As reported in figure 2,
banks have borrowed roughly 0.3% of
required reserves since 2003, com-
pared with 2.7% prior to 1990 and be-
tween 0.4% and 0.7% during the 1990s.
Upon further consideration, it is perhaps
not surprising that variation in required
reserves has little impact on discount
window borrowing. Increased branch
and ATM networks have increased the
vault cash holdings of commercial banks,
making it far more likely that a bank
would be able to satisfy its reserve re-
quirement through the holding of vault
cash.9 As a result, required reserve balances,
defined as the difference between re-
quired reserves and applied vault cash,
may be a more appropriate scale by
which to measure the use of the discount
window. Figure 3 plots the ratio of dis-
count window borrowing to required
reserve balances. Figure 3 shows that,
in particular, increases in discount
window borrowing are most obviously
related to problems with Continental
Illinois in 1984, Y2K, and September 11,
2001. What seems apparent is that dis-
count window borrowing as a fraction
of required reserve balances was not
ratio
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1975 ’77 ’79 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 2001 ’03Michael H. Moskow, President; Charles L. Evans,
Senior Vice President and Director of Research;  Douglas
Evanoff, Vice President, financial studies; David
Marshall, Vice President, macroeconomic policy research;
Richard Porter, Senior Policy Advisor, payment
studies; Daniel Sullivan, Vice President, microeconomic
policy research;  William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System.
© 2005 Federal Reserve Bank of Chicago
Chicago Fed Letter articles may be reproduced in
whole or in part, provided the articles are not
reproduced or distributed for commercial gain
and provided the source is appropriately credited.
Prior written permission must be obtained for
any other reproduction, distribution, republica-
tion, or creation of derivative works of Chicago Fed
Letter articles. To request permission, please contact
Helen Koshy, senior editor, at 312-322-5830 or
email Helen.Koshy@chi.frb.org. Chicago Fed
Letter and other Bank publications are available
on the Bank’s website at www.chicagofed.org.
ISSN 0895-0164
4. Reserve balances and the payment system
SOURCE: www.federalreserve.gov/paymentsystems/fedwire/wirequarterly.htm.
ratio Fedwire value ($ trillion)
Required reserve balance turnover
Daily fedwire value
all that low during the late 1990s com-
pared with the pre-1990 experience.
As reported in figure 2, abstracting
from the aforementioned specific
events, discount window lending ac-
counted for 3.6% of required reserve
balances between 1975 and 1990 and
3.2% of required reserve balances be-
tween 1997 and 2002. Since the imple-
mentation of the new primary credit
facility, discount window borrowing
has accounted for about 1.1% of re-
quired reserve balances.
Reserve balances and the payment
system
The demand for reserve balances is
increasingly being driven by growth in
interbank payment activity rather than
by minimum reserve requirements.10
Figure 4 plots the aggregate value of
interbank payments processed over
Fedwire, the large-value payment system
owned and operated by the Fed. The
value of aggregate Fedwire payments
increased from roughly $1.3 trillion a
day in 1992 to roughly $3 trillion a day
in early 2004. These payments are fund-
ed from an aggregate reserve balance
that, as of the first quarter of 2004, aver-
aged only $11.5 billion. To facilitate
an efficient payment system, the Fed
allows banks to maintain limited nega-
tive reserve balances during the business
day at a low cost (currently 27 basis points
at an annual rate), but imposes a stiff
400 basis point penalty on negative
balances held overnight. Before 2003,
banks faced with an unexpected nega-
tive balance late in the day might have
gone to the discount window, but for
reasons mentioned
above, they may have
remained reluctant.
If the new primary
credit facility reduced
the perceived stigma
of borrowing from
the Fed, it is more
likely that a bank in
this situation would
borrow from the cen-
tral bank and pay a
penalty of only 100
basis points.
As the ratio of pay-
ment flows to reserve
balances increases, it
seems more likely that
a bank might face a
last-minute need for
liquidity to avoid an overnight over-
draft.11 Thus, reserve balance turnover,
defined as the ratio of payment value to
required reserve balances, might reason-
ably be related to the possible need for
discount window loans. Figure 4 graphs
this ratio. Balance turnover increased
rapidly beginning in the mid-1990s and
reached a peak of over 500 during the
first quarter of 2000. Since that time,
however, it has been declining, falling
by half as of the beginning of 2004, as
required reserve balances have increased
rapidly since 2000 and deposits at com-
mercial banks subject to reserve require-
ments have similarly expanded. Overall,
figure 2 shows that the average reserve
balance turnover was 322 between 1997
and 2002  and 286 since the beginning
of 2003, but again, this difference in
averages hides the more dramatic in-
crease and subsequent decline in reserve
balance turnover apparent in figure 4.
Thus, one interpretation of the high-
er ratio of discount loans to required
reserve balances between 1997 and
2002 is that higher payment flows in-
creased uncertainty in bank reserve
accounts, leading to greater use of loans
from the Fed. The apparent decline
in borrowing since early 2003 would
analogously be attributable to the low-
er turnover witnessed more recently.
Recent discount window borrowing
and interest rate volatility
Since the rate on primary credit bor-
rowing is currently set at 100 basis
points over the Fed’s target federal
funds rate, one might assume that the
low-cost motivation for borrowing
would no longer be present. This need
not necessarily be the case, however,
since any given bank may face rates in
excess of the market (average) rate.12
One proxy for the expected demand
for primary credit would be the volatil-
ity of the interbank market rate. As
shown in figure 2, overnight interest
rates were more stable after 2003. The
average absolute funds rate deviation
from target was approximately 9 basis
points between 1997 and 2002, but
only 5 basis points since January 2003.
Thus, borrowing from the Fed’s pri-
mary credit facility may increase if the
volatility of interbank interest rates re-
turns to past levels.
Conclusion
Borrowing from the Federal Reserve’s
discount window remains low. However,
when put in perspective, discount win-
dow borrowing relative to required re-
serve balances between 1997 and 2002
was at levels similar to those of the years
before banks became reluctant to bor-
row from the Fed in the early 1990s.
More recently, discount window borrow-
ing has been lower, but this could have
been partially expected given the decline
in payment-related balance turnover
and reduced interest rate volatility.
0
100
200
300
400
500
600
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
1992 ’93 ’94 ’95 ’96 ’97 ’98 ’99 2000 '01 ’02 ’03 ’041 These are the initial values and could be
changed by the Fed.
2 This is in contrast to discount window
use during financial crises. See Christopher
J. Neely, 2004, “The Federal Reserve re-
sponds to crises: September 11th was not
the first,” Review, Federal Reserve Bank of
St. Louis, Vol. 86, No. 2.
3 This might happen, for example, when
the Fed’s supply of non-borrowed reserves
was low relative to the banks’ aggregate
reserve requirement. See David L. Mengle,
1993, “The discount window,” Instruments of
the Money Market, Timothy Q. Cook and
Robert K. Laroche (eds.), Richmond, VA:
Federal Reserve Bank, chapter 3, available
at www.rich.frb.org/pubs/instruments/.
4 See Stavros Peristiani, 1998, ‘The grow-
ing reluctance to borrow at the discount
window: An empirical investigation,” Review
of Economics and Statistics, Vol. 80, No. 4,
pp. 611–620.
5 Good financial condition requires a
CAMELS (capital, asset quality, manage-
ment, earnings, liquidity, and sensitivity)
rating of no more than 3 and at least ade-
quate capitalization.
6 See Brian F. Madigan and William R.
Nelson, 2002, “Proposed revision to the
Federal Reserve’s discount window lending
programs,” Federal Reserve Bulletin, July,
pp. 313–319.
7 See Federal Reserve, 2003, “Agencies is-
sue guidance on appropriate use of dis-
count window,” press release, July 23.
8 Evidence on bank-specific rates paid on
federal funds borrowed is approximated
from payment flow data. See Craig H.
Furfine, 2003, “Standing facilities and in-
terbank borrowing: Evidence from the
Fed’s new discount window,” International
Finance, Vol. 6, No. 3, pp. 329–347.
9 See, for example, Paul Bennett and Stavros
Peristiani, 2002, “Are U.S. reserve re-
quirements still binding?,” Economic Policy
Review, Federal Reserve Bank of New York,
and Gordon H. Sellon, Jr., and Stuart E.
Weiner, 1996, “Monetary policy without
reserve requirements: Analytical issues,”
Economic Review, Federal Reserve Bank of
Kansas City, Fourth Quarter.
10See Craig H. Furfine, 2000, “Interbank
payments and the daily federal funds rate,”
Journal of Monetary Economics, Vol. 46, No. 2,
pp. 535–553.
11Two factors work in the other direction.
First, higher payment flows have been ac-
companied by technological improvements
in bank cash management practices that
allow for a closer monitoring of incoming
and outgoing payments, thus reducing the
scope for late-afternoon reserve balance
surprises. Second, banks have increasingly
relied upon “required clearing balances”
as a means to acquire remuneration on re-
serves held at the Fed (see Bennett and
Peristiani, 2002). These balances have ex-
panded rapidly and are roughly the same
order of magnitude as required reserve
balances. Thus, had discount window
borrowing been scaled to the sum of re-
quired reserve balances and required
clearing balances, the apparent 1997–2002
increase in discount window borrowing
would appear more muted.
12An analysis of payment flow data suggests
that although the market average rate is
typically close to the target federal funds
rate, differences occur across banks with
respect to the average spread relative to
the market. See Craig H. Furfine, 2006,
“The costs and benefits of moral suasion:
Evidence from the rescue of Long-term
Capital Management,” Journal of Business,
forthcoming.

Discount window borrowing: understanding recent experience

http://www.chicagofed.org/digital_assets/publications/chicago_fed_letter/2005/cflmarch2005_212.pdf

Discount window borrowing: understanding recent experience

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics