Discount rate overview
In the article about Federal Funds rate we talked about the rate that dictates the interest rate for the inter-bank lending. But banks can also borrow directly from the Federal Reserve, that’s where the discount rate comes to play.
The discount rate (also “discount window rate”) is the interest rate that the Federal Reserve charges banks to borrow funds directly from its discount window. The discount rate is typically higher than the Federal Funds rate, and borrowing from the discount window is generally considered a last resort for banks, as it can signal that a bank is experiencing financial difficulty.
Financial institutions can borrow from the discount window for a short period, usually overnight, to meet their temporary liquidity needs. The discount rate is higher than the federal funds rate, which is the interest rate that banks charge each other for overnight loans. The discount rate is set higher to encourage banks to borrow from each other before resorting to the discount window, which is seen as a last resort.
Banks must meet certain requirements and be in good standing with the Federal Reserve to be eligible to borrow from the discount window. The Federal Reserve uses its discount window lending as a tool to help maintain stability in the banking system and to provide a backup source of liquidity for banks when necessary.
When do commercial banks use discount window
Commercial banks typically decide to use the discount window when they face temporary liquidity shortages or unexpected funding needs. For example, if a bank experiences a sudden increase in customer withdrawals or a large loan repayment, it may find itself short of cash reserves to meet its obligations. In such situations, the bank may choose to borrow from the discount window to bridge the gap until its cash inflows catch up with its outflows.
Banks may also use the discount window if they are unable to borrow from other banks or the money markets due to concerns about their creditworthiness. In such cases, borrowing from the Federal Reserve may be seen as a more reliable source of funding.
However, banks are generally reluctant to use the discount window because it carries a stigma of being a sign of financial weakness. Additionally, borrowing from the discount window may signal to regulators and the public that the bank is facing financial difficulties, which can negatively impact its reputation and stock price.
Primary and secondary credit rates
The Federal Reserve Discount Window has two interest rates: the primary credit rate and the secondary credit rate.
- The primary credit rate is the interest rate at which healthy financial institutions can borrow from the discount window for a short period of time, usually overnight, to meet their temporary liquidity needs. The primary credit rate is typically lower than the secondary credit rate, and it is set slightly above the federal funds rate, which is the interest rate at which banks lend to each other. It’s currently the high end of the fed target rate range.
- The secondary credit rate is the interest rate charged to financial institutions that do not qualify for primary credit due to weaker financial conditions. Banks that borrow at the secondary credit rate may have to provide additional collateral and are subject to more stringent terms and conditions than banks that borrow at the primary credit rate. Currently 0,5% hither than the primary.
Historical Discount window usage cases
In 2002, one of the most prominent cases of discount window usage occurred when JP Morgan Chase used the facility to borrow $5 billion in the wake of the collapse of Enron, one of its major clients. The move helped JP Morgan Chase avoid a liquidity crisis and maintain confidence in its ability to meet its financial obligations.
However this was nothing compared to financial crisis. In 2008 many banks faced severe liquidity problems and turned to the discount window to borrow funds from the Federal Reserve. The discount window played a critical role in preventing a widespread collapse of the banking system by providing short-term funding to banks that were struggling to raise funds in the private market.
But also in 2019, several regional US banks used the discount window to borrow funds from the Fed amid a liquidity squeeze in the overnight lending market. This borrowing helped stabilize the market and ease concerns about a potential credit crunch.
Overall, while the Discount Window is seen as a lender of last resort, it can play a critical role in maintaining financial stability during periods of stress or uncertainty.