Fed's Discount Facility Now More Effective

Things were different in 1968, when I first studied Money and Banking as an economics major, especially the Federal Reserve's ability to shore up financial markets.

That ability has been in the spotlight in the past week, as banks reeled in credit lines, and the Fed stepped in to relieve a crunch in the money markets by injecting more funds than was strictly necessary to keep bank reserves at required levels. The central bank's ability to act has improved significantly in the past forty years thanks to two changes that affect the discount window. The first change expanded the number of institutions allowed to tap the window. The second made discount borrowing less onerous. Back in the 1960s, the discount rate - along with open market operations and reserve requirements - was a monetary policy tool, rather than a liquidity management tool, as it is now. (The now so important federal funds target rate only became the primary monetary policy tool in the 1970s.) But even as a policy tool, the discount rate's usefulness was greatly limited. It was only available to those commercial banks which were members of the Federal Reserve system - and not all of them were. Moreover, the discount rate was then below the federal funds rate, presenting a less expensive way for banks to finance their lending. As a result, borrowing through the discount facility was a privilege to member banks that they were wary of overusing. If a bank utilized the facility more than once or twice a year, the president of the Fed district bank would call and inquire whether there was a problem at the bank - a question no bank management wanted to hear. Since then, the discount rate's role in monetary policy has diminished. Instead, it is now a liquidity tool; as the Fed reminded banks that may be seeing "unusual funding needs" last week, "as always, the discount window is available as a source of funding."

In Line With Other Central Banks

Two changes have strengthened the discount window's function - one of them introduced not that long ago. "I think the Fed is in a better position now to add liquidity to the financial system because of the Monetary Control Act of 1980 and the change in the way the Fed lent through the discount rate in 2003," said Ray Stone, a veteran market observer who is a partner at Stone & McCarthy Research Associates in Princeton, N.J. The Depository Institutions and Monetary Control Act of 1980 extended the discount lending facility to all depository institutions who held clearing balances, not just the member commercial banks. That "extended the discount facility to savings and loans, mutual savings banks, credit unions, and branches and agencies of foreign commercial banks in the U.S.," said Lou Crandall, chief economist at Wrightson ICAP in Jersey City, N.J., another veteran observer. In addition, effective Jan. 9 2003, the Fed changed the relationship between the discount rate and the fed funds rate, bringing its use in line with that of other central banks. It replaced the old, below-market rate discount borrowings with a "new type of discount window credit called primary credit." What that meant was that the Fed keeps the discount rate 100 basis points above the fed funds target rate. Currently, the discount rate is at 6.25%, and fed funds are at 5.25%.

More Reserves When They're Needed

Thanks to the changes in the 1980s, a broader spectrum of institutions can now tap the discount window, though, since 2003, they do have to pony up for that privilege. "The borrowing reach has broadened and making the discount rate a penalty rate (above the fed funds rate) has removed some of the onus from borrowing at the discount window," said Stone & McCarthy's Stone. As a result, institutions being squeezed may be more prepared to use the facility. One way to find out whether, in the recent market upheaval, borrowings at the discount window were utilized to a greater degree than usual, will be to examine the Fed's H 4.1 report for the week to Wednesday, to be published at 4:30 p.m. EDT on Thursday. Table 4, which shows the statement of condition of each Federal Reserve Bank on that date includes a line item, under the assets termed simply "loans," which are discount loans in each district. In the week ended Aug. 8, the total in discount borrowings was a mere $255 million. A jump in the use of the discount window will be worth looking at to see if the credit problems really have spread. Those like me who have been around for a while remember well how closely markets in 1984 monitored that table, and the borrowings in the Chicago Fed's district, as Continental Illinois, then among the 10 largest banks in the U.S., headed for failure. It's a new economic indicator to watch again.