Date: February 24, 2020
From: Bill Nelson
Subject: The Discount Window Is Available to Meet Liquidity Needs
Following up on my email from Saturday, which addressed the Fed’s potential monetary policy response to a pandemic, this post offers a few thoughts on how the Fed could use its liquidity and supervisory tools to respond.
On September 11, 2001, the Federal Reserve Board issued a two-line press release:
The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.
Such an announcement is a standard part of the Fed’s response to severe events. Indeed, the Fed has had since 2004 a thick binder, referred to as the “survival binder,” that lists different types of crises that can occur, what steps to take in response, and what tools are available to respond to the crisis. The first step in responding to each crisis is usually “issue a statement that the discount window is available” and perhaps lower the discount rate.
As we contemplate the potential for Covid-19 to spread to the United States, it is worth remembering that, at least since 2003, the discount window is always available. In 2003, the Fed changed Regulation A, the regulation that governs Fed lending, to state that primary credit (the main type of discount window lending) is a “no-questions-asked” facility and that there were no restrictions on its use. Moreover, the Fed, OCC, NCUA, and OTS issued an SR letter (SR letter 03-15) shortly after the discount window was revamped encouraging banks to view the discount window as an important and viable source of contingency funding.
Banks have also built huge stockpiles of liquid assets in response to prudent risk management, regulatory requirements, and supervisory expectations. Large banks now hold about 20 percent of their portfolio in high-quality liquid assets (HQLA) such as deposits at the Fed, Treasury securities, and agency-guaranteed mortgage-backed securities. Unfortunately, as BPI discussed in “Unlocking the liquidity coverage ratio,” the way the rules are written make it nearly impossible for banks to use the liquid assets they have set aside to meet liquidity needs.
Recently, the Bank of England revised its guidance on use of HQLA to clarify that there was no expectation that banks would first use up their own resources before borrowing. (See “Constructive Disambiguity About the Discount Window” and the references cited therein). Specifically, the Bank of England stated:
All of the Bank of England’s liquidity facilities are intended to be open for business. As such there is no presumptive order of use for firms between using the Bank of England’s liquidity facilities, including the Discount Window Facility (DWF), and drawing down of their liquidity buffers to meet a liquidity need.
A similar clarification from the Fed would help, at least a bit, with discount window stigma and HQLA usability.
In mid-September, turmoil erupted in repo markets when tax payments and Treasury settlements combined to cause a huge mismatch between repo demand and supply. That turmoil, which occurred during an otherwise unremarkable period characterized by low counterparty credit concerns, was a demonstration of how post-crisis regulatory reforms, supervisory mandates, and changes to banks’ risk-management practices have increased financial market rigidity. If the coronavirus comes to the United States, market liquidity will dry up further as market participants stay home, and counterparty credit concerns will rise.
So if things get worse the Fed may need to take a page from its survival binder and a few more tools it developed during the crisis (see here) to craft a response:
- Issue a statement that the discount window is available.
- Cut the discount rate 25 bp
- Lengthen the term of discount window loans to 90 days.
- Issue a statement that banks should use their HQLA to meet liquidity needs.
- Open the primary dealer credit facility (the discount window for primary dealers developed in the crisis).
Comments and discussion welcome.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Bank Policy Institute or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.