The Fed is conflicted about lending—lending as tool for monetary policy implementation as well as lending as a tool to address a financial crisis. On the one hand, it has been struggling for at least a half century to counter the reluctance of banks to borrow from the Fed at its discount window. As long as there is a stigma associated with doing so, Fed lending cannot accomplish effectively either its monetary policy or its financial stability function. On the other hand, for even longer, the Fed has been a reluctant lender out of concern that excessive borrowing undermines banks’ risk management. In just the past few weeks the Fed has simultaneously indicated it is considering two separate but conceptually related actions—first, establishing a lending facility intended to encourage borrowing and reduce banks’ holdings of excess reserves (i.e., deposits of banks at the Fed in excess of reserve requirements) and, second, imposing new liquidity requirements designed to even further reduce the likelihood of borrowing and increase banks’ holdings of excess reserves. The cognitive dissonance between these proposals is ironic, given that one area where there appears to be widespread agreement is that a key component of reducing stigma is increasing banks’ clarity about their capacity to borrow from the Fed.
In two recent blog posts (here and here), Fed economists David Andolfatto (St. Louis Fed) and Jane Ihrig (Board) argue that the Fed should have a standing repo facility as part of its new monetary policy implementation framework both to reduce reserve demand and to increase interest rate control. The facility would allow commercial banks to conduct Treasury repos with the Fed at a known and fixed interest rate (that is, the rate does not respond to use of the facility). The Federal Open Market Committee has stated in minutes to the December, January, and March meetings that it is considering additional tools along the lines of a standing repo facility. The March minutes indicate the Committee would like to discuss such tools further, possibly signaling that they may do so at the FOMC meeting this week. If so, Chairman Powell will probably at least mention it at his press conference Wednesday afternoon.
Ihrig and Andolfatto list reducing banks’ demand for excess reserves as a key objective of such a facility. That demand depends importantly on the substitutability between Treasury securities and reserves. The relative advantage of reserves is that they can be used to make a payment of unlimited size instantly while it takes time to convert a large amount of Treasuries into liquidity, with the cash not necessarily available same day. If the Fed had a standing repo facility for banks that charged only a small spread above market rates and was open until the close of Fedwire (the Fed’s large-value payments system), Treasuries and reserves would become much closer substitutes. As the authors note, this could shift reserve demand “much closer” [emphasis theirs] to their historical levels. The authors also argue that if such a facility existed, “…regulators should feel more comfortable in treating U.S. Treasuries on par with reserves for resolution purposes.”
At a BPI symposium in January, several bank participants indicated that their demand for excess reserves was informed by a determination to never again borrow from the discount window. For a variety of reasons, there has always been a stigma associated with borrowing from the discount window, and that stigma intensified sharply following the financial crisis because of public vilification of institutions that borrowed. A recent study by the New York Fed concluded that if banks are unwilling to borrow from the discount window they need up to $934 billion in excess reserve balances to cover potential day 1 stress outflows.
A standing repo facility could reduce stigma in several ways. Most importantly, there currently is no stigma when a primary dealer engages in a vanilla monetary policy repo with the Fed. Packaging repos at the standing facility as monetary policy operations could grant them stigma-free status.
The facility would also include other characteristics that have been proposed as ways to reduce stigma:
- Unlike the discount window, which takes all types of bank assets as collateral, the standing repo facility would only take Treasury securities. A bank that has Treasury securities to spare is probably not in financial distress.
- Unlike the discount window, the interest rate on the standing repo facility would not be at a penalty, so using the facility would seem less desperate.
One reason why there may nevertheless be stigma associated with borrowing from the repo facility is that it would essentially be subject to the same degree of transparency and publicity as the discount window. In both cases, the Fed is required to publish details of the transaction, including the borrower, after two years. If repos at the standing facility could be convincingly characterized primarily as monetary policy operations, rather than as sources of liquidity to institutions under stress, the facility could avoid the stigma that has hampered the functioning of the discount window
Reducing the stigma associated with borrowing from the Fed would have two important benefits in addition to reducing banks’ demand for excess reserves. First, it would enable the Fed lending rate, whether from the discount window or a standing repo facility, to put a cap on overnight interest rates (because, absent stigma, no bank should borrow in money markets for more than it can borrow from the Fed). The lack of an effective cap is one of the reasons that the Fed has decided to continue to conduct monetary policy using a “floor system,” with a large balance sheet, as opposed to a “corridor system,” with a smaller balance sheet. (A primer on the Fed’s implementation framework debate can be found here.)
Second, if banks are unwilling to borrow from the discount window, then the Fed’s primary tool for responding to a financial crisis won’t work. In the middle of the Global Financial Crisis, the President’s Working Group and the Financial Stability Forum (later the Financial Stability Board (FSB)) identified reducing discount window stigma as a critical change needed to enhance authorities’ ability to respond to a financial crisis.[1] In April 2008, the FSB indicated:
If anonymity is not well preserved, or if senior bank management and bank regulators are not completely familiar with the role of standing loan facilities for meeting frictional needs, as uncertainty mounts there is a greater risk that borrowing from a central bank loan facility would be regarded as a sign of weakness. If that were to occur, the effectiveness of the loan facility as a liquidity backstop would be severely impaired.”
A July 2008 report by a working group of the Committee on the Global Financial System on the tools central banks were using to respond to the crisis similarly indicated that reducing stigma would be desirable. The group concluded:
Central banks should continue their efforts to reduce stigma by, for example, enhancing the understanding of the role of such facilities and designing new facilities that are less associated with past instances of emergency assistance.”
While the Fed is contemplating opening a new lending facility to make banks comfortable holding lower levels of excess reserves, it is simultaneously enforcing regulations and even suggesting new regulations designed to make banks hold more excess reserves intended to reduce the likelihood of borrowing. In a recent request for public comment on a potential regulation, the Fed cited borrowing by U.S. branches and agencies of foreign banks at the discount window during the financial crisis as a motivation for possibly stiffening liquidity requirements on branches and agencies. Large banks are required to maintain enough liquidity to fund their liquidation in event of failure without use of the discount window.[2] The Liquidity Coverage Ratio, a component of the Basel III post-crisis reforms, requires banks to hold sufficient liquid assets to meet short-term liquidity needs in a crisis assuming the bank is unable to borrow from the discount window.
The Fed’s discount window lending programs are governed by its Regulation A. In 2003, the regulation was revised to create two new lending programs: primary credit and secondary credit. Primary credit is available to generally sound banks at an above market rate with little administration, that is, on a “no-questions-asked” basis. The regulation states that Secondary credit is available to weaker banks as a “backup source of funding”
…if, in the judgment of the Reserve Bank, such a credit extension would be consistent with the timely return to a reliance on market funding sources [or if] such credit would facilitate the orderly resolution of serious financial difficulties of a depository institution.”
A few months after the opening of the primary and secondary credit programs, The Fed, OCC, FDIC, OTS, and NCUA issued a supervisory letter providing supervisors and depository institutions information about the availability of primary credit as a new tool for liquidity risk management. The letter states:
“The new primary credit program has the following attributes that make the discount window a viable source of back-up or contingency funding for short-term purposes:
- A less burdensome administrative process than applied under the previous adjustment credit program makes primary credit a simpler and more accessible source of backup, short-term funding.
- Primary credit can enhance diversification in short-term funding contingency plans.
- Discount window borrowings can be secured with an array of collateral, including consumer and commercial loans.
- Requests for primary credit advances can be made anytime during the day.
- There are no restrictions on the use of short-term primary credit. “[3]
The 2003 revisions to the discount window made no changes to the seasonal credit program, a discount window lending program created in the early 1970s to help community banks manage seasonal swings in lending and deposits. In the four quarters ending in 2017Q1, the most recent data available, the Fed extended 1,088 discount window loans under the seasonal credit program. According to the Board’s website:
Eligible depository institutions may borrow term funds from the discount window during their periods of seasonal need, enabling them to carry fewer liquid assets during the rest of the year and, thus, allow them to make more funds available for local lending.”
Note that seasonal credit, which is largely free of stigma, is intended to enable banks to hold lower levels of reserves balances in a manner similar to the contemplated standing repo facility. Note also the recognition by the Fed that enabling banks to hold lower levels of liquid assets is socially beneficial because it allows the banks to make more loans to households and businesses.
A recurrent theme that has pervaded efforts to improve the discount window has been the importance that banks have a clear understanding of their borrowing privilege. The 1971 “Reappraisal of the Discount Window” states:
Failure of the Federal Reserve to communicate clearly, consistently, and unambiguously with member banks regarding the availability of discount-window accommodation has caused many of these banks to view this as an uncertain source of credit. In addition, occasional Federal Reserve counsel as to what would be regarded as appropriate adjustments for borrowing banks has led many banks to regard the window as having too great a potential for interfering with bank management decisions.”[4]
A 2002 Federal Reserve Bulletin article explaining the reasons for the 2003 revisions states
…depository institutions have often cited uncertainty about their borrowing privileges as a reason for their reluctance to borrow…The establishment of a lending program with an above-market rate would sharply reduce the need for the administration of the window. Reduced administration would encourage greater uniformity in the administration of the discount window across Federal Reserve Districts. It should also mitigate institutions’ reluctance to borrow when money markets tighten sharply by minimizing Reserve Bank questioning, by significantly increasing the comprehensibility of the rules regarding credit extension, and by eliminating the requirement that institutions first attempt to secure funds elsewhere.”
And, as quoted above, the FSB concluded stigma arose when “…senior bank management and bank regulators are not completely familiar with the role of standing loan facilities for meeting frictional needs,” and the CGFS report concluded stigma could be reduced by “…enhancing the understanding of the role of such facilities…”
Despite understanding the importance of clarity about the discount window for at least 50 years, the Fed’s current policy toward borrowing is muddled. Regulation A states that Seasonal Credit is intended to reduce bank holding of liquid assets so that they can lend more to their community, that primary credit is intended to be a reliable source of contingency funding, and that Secondary Credit is intended to facilitate an orderly resolution. Interagency supervisory guidance encourages banks to see the discount window as a reliable component of a contingency funding scheme. At the same time, multiple regulations adopted by the Fed are designed to discourage banks from borrowing at the window and to hold more liquid assets instead; banks are forbidden from planning on discount window credit facilitating an orderly resolution; and FBOs may be singled out for heightened regulatory stringency precisely because they borrowed from the discount window in the crisis.
These recent regulatory actions of the Board are in heavy tension with, if not outright inconsistent with, the clear policy stance on Fed lending it has previously articulated in its rules and elsewhere. This is unfortunate, as the FSB, CGFS, and decades of previous Fed Boards have understood that such ambiguity diminished the effectiveness of the discount window as a monetary policy and financial stability tool.
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.
[1] See The President’s Working Group on Financial Markets, March 2008, p.9, FSF Working Group on Market and Institutional Resilience, April 7, 2008, p.47, and FSF Working Group on Market and Institutional Resilience, October, 10, 2008, p.35
[2] See “Fed blow to banks over ‘living wills’”, Financial Times, August 17, 2014.
[3] More recently, the NCUA has required credit unions to be signed up to borrow from the Fed, or from the NCUA, for contingency purposes. https://www.ncua.gov/files/letters-credit-unions/LCU2013-10.pdf
[4] Board of Governors of the Federal Reserve System (1971), “Reappraisal of the Federal Reserve Discount Mechanism. p.9
