BPI’s Bill Nelson Testifies at House Hearing on Discount Window

Washington, D.C. — BPI Chief Economist Bill Nelson will testify today at a House Financial Services Subcommittee on Financial Institutions and Monetary Policy hearing entitled “Lender of Last Resort: Issues with the Fed Discount Window and Emergency Lending.” Nelson’s testimony emphasizes the necessity and benefits of recognizing the Federal Reserve’s discount window as a regular tool for maintaining liquidity in the banking system – not just as an emergency source of funding.

The stigma problem: The discount window serves two purposes – as an unremarkable monetary policy tool and a source of contingency funding for banks. This dual nature of discount window lending has attracted stigma for the last century. Responses to discount window borrowing in the Global Financial Crisis exacerbated the stigma.

“Consequently, one of the Fed’s most important monetary policy and financial stability tools doesn’t work well,” Nelson said in the testimony. “While it is tempting to conclude that stigma is irrelevant because a bank will borrow if it has to, that is incorrect for two reasons.  First, in many cases it is not the borrowing bank that is experiencing the liquidity strains but rather a third party, and the Fed is seeking to get banks to intermediate to that third party.  That indirect approach will not work if banks won’t borrow.  Second, a critical purpose of the discount window is to make banks confident that they will have the funds they need to meet draws on credit lines, deposit withdrawals, or other cash outflows so that they are not forced to pull back from lending or sell assets at fire-sale prices … If using the discount window would get you fired, the fact that you technically have access to the window isn’t going to provide much comfort.”

Another source of stigma: Liquidity requirements, such as the liquidity coverage ratio and internal liquidity stress tests, do not recognize discount window and pre-positioned collateral at the window as sources of bank liquidity. These restrictions contradict the reality that a bank prepared to borrow from the window is more liquid than one that is not. Regulators have told banks to be willing to borrow, but these messages ring hollow when such borrowing capacity is not recognized in liquidity evaluations.

What may come next: Policymakers and analysts have recently contemplated liquidity rule changes that could recognize banks’ readiness to borrow from the discount window. Such recognition could make liquidity assessments more accurate and motivate banks to be prepared to borrow. Banks addressing more short-term contingency funding needs with discount window borrowing, not reserves, could leave room on their balance sheets to lend more to businesses and households instead of amassing government securities or deposits at the Fed. 

Why it matters: Recognition of the discount window as a critical tool to address banks’ funding needs both in ordinary times and in stress would promote stability in the banking system and make the Federal Reserve a more effective lender of last resort in crisis.

Recommendations: Policymakers should consider the following steps:

  • Selling banks committed liquidity facilities, or CLFs, which could serve as a backup source of funding in contingencies.
  • Reducing discount window stigma through education and eliminating the requirement for borrowers to be publicly identified.
  • Investigating obstacles to banks pledging collateral at the discount window.
  • Proposing any liquidity rule changes as an advance notice of proposed rulemaking to ensure relevant stakeholder input is taken into account.

Nelson oversaw discount window policy as a deputy director of the Federal Reserve Board’s Monetary Affairs Division.

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The Bank Policy Institute (BPI) is a nonpartisan public policy, research and advocacy group, representing the nation’s leading banks and their customers. Our members include universal banks, regional banks and the major foreign banks doing business in the United States. Collectively, they employ almost 2 million Americans, make nearly half of the nation’s small business loans, and are an engine for financial innovation and economic growth.

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Bank Policy Institute
tara.payne@bpi.com

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