Which of the following is a likely effect when the discount window is closed?

The Fed offers three types of discount window lending programs to financial institutions: primary credit, secondary credit, and seasonal credit.

Note

The Fed offers primary credit on a very short-term basis to institutions that are generally in good financial health.

If an institution doesn't meet the eligibility requirements for primary credit, it can try for secondary credit, which has a slightly higher interest rate. The Fed also offers seasonal credit to smaller institutions to help them make loans to farmers, students, resorts, and other seasonal borrowers.

The borrowing banks must post collateral to the Fed in return for the loan. Such collateral can include U.S. Treasury notes and municipal government securities. It can also include AAA mortgages, consumer loans, and commercial loans. In 1999, the Federal Reserve also accepted investment-grade Certificate of Deposits and AAA-rated mortgage-backed securities.

You can find the current interest rates for the discount window lending on the Federal Reserve website. These rates are usually higher than the fed funds target rate because it prefers that banks borrow from each other and only use the discount window as a last resort. 

Note

The Fed raises and lowers its rates via the Federal Open Market Committee, which meets eight times a year.

The Discount Window and Monetary Policy

The Fed also uses the discount window and its other tools to implement monetary policy. For example, it raises the discount rate when it wants to reduce the money supply. It raises the fed funds rate at the same time. That gives banks less money to lend, slowing economic growth. That's called contractionary monetary policy, and it's used to fight inflation. 

The opposite is expansionary monetary policy, and it's used to stimulate growth. To do this, the Fed lowers the discount and fed funds rates. That increases the money supply and gives banks more money to lend.

Note

The Fed has many other tools that it uses to expand or constrict bank lending. 

Its most heavily used tool is open market operations. To expand lending, it buys the bank's securities. It replaces them with credit on a bank's balance sheet. This gives the bank more money to lend. To constrict lending, the Fed replaces the bank's cash with securities. The bank doesn't have a choice when the Fed wants to sell securities. 

History of the Discount Window

When the Fed was established in 1913, the discount window was its primary tool. It provides a necessary safety valve in times of emergency. For example, during the 1999 Y2K scare and again after the 9/11 attacks, the Fed loosened its constraints to make sure banks had plenty of money. 

At that time, the Fed required that banks prove they had no other source of funds. The reason was that the discount rate was lower than the fed funds rate. Many banks avoided the discount window even when they needed it.

In January 2003, the Fed replaced that system with the primary and secondary programs. Although desperate, banks still need to have good collateral to even qualify for the primary program. If they are really in bad shape, they can only be eligible for the secondary program. But for a poorly run bank, it's still preferable than going out of business and being taken over by the Federal Deposit Insurance Corporation. 

In general, banks can rely on the discount window to supply liquidity when normal operations freeze up. During the 2008 financial crisis, the Fed used the discount window to pump extra liquidity into the market. It did the same during the 2020 coronavirus pandemic.

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The discount window is a central bank lending facility meant to help commercial banks manage short-term liquidity needs. Banks that are unable to borrow from other banks in the fed funds market may borrow directly from the central bank's discount window paying the federal discount rate.

Current discount rates are listed on the Federal Reserve's website.

Key Takeaways

• The discount window is a central bank facility that offers commercial banks very short-term loans (often overnight).
• The Federal Reserve extends discount window loans to financial institutions that, in turn, support commercial industries.
• The discount window rate is higher than the fed funds target rate, which encourages banks to borrow and lend to each other and only turn to the central bank when necessary.
• The discount window is also used for central banks when they act as lenders of last resort.

How a Discount Window Works

The Federal Reserve and other central banks maintain discount windows, referring to the loans they make at an administered discount rate to commercial banks and other deposit-taking firms.

Discount window borrowing tends to be short-term—usually overnight—and collateralized. These loans are different from the uncollateralized lending banks with deposits at central banks do among themselves; in the U.S. these loans are made at the federal funds rate, which is lower than the discount rate. Even foreign banks may borrow from the Federal Reserve's discount window.

Banks borrow at the discount window when they are experiencing short-term liquidity shortfalls and need a quick cash infusion. Banks generally prefer to borrow from other banks, since the rate is cheaper and the loans do not require collateral.

The term refers to the now obsolete practice of sending bank employees to actual, physical windows in Federal Reserve branch lobbies to ask for loans.

For this reason, discount window borrowing tends to rise during spells of economy-wide distress, when all banks are experiencing some degree of liquidity pressure. Borrowing from the central bank is a substitute for borrowing from other commercial banks, and so it is seen as a lender of last-resort measure once the interbank overnight lending system has been maxed out. The Federal Reserve sets this interbank rate, called the Fed funds rate, which is usually set lower than the discount rate.

Example of a Discount Window

The 2008 financial crisis saw the Fed's discount window take on a central role in maintaining a semblance of financial stability. Lending periods were extended from overnight to 30 days, then 90. The rate was cut to within 0.25 percentage points of the federal funds rate; the spread had previously been 1 pp, and as of November 2017, it is 0.5 pp.

Special Considerations

The Fed's discount window lends at three rates; "discount rate" is shorthand for the first-rate offered to the most financially sound institutions. The three rates are defined as the primary credit rate, secondary credit rate, and seasonal discount rate. All other interest rates are affected by the discount rate including savings and money market interest rates, fixed-rate mortgages, and LIBOR rates.

According to the Federal Reserve website:
"Bankers' banks, corporate credit unions, and other financial institutions are not required to maintain reserves under Regulation D, and so do not have regular access to the Discount Window. However, the Board of Governors has determined that such institutions may obtain access to the Discount Window if they voluntarily maintain reserves."

Federal Discount Rate vs. Federal Funds Rate 

The federal discount rate is the interest rate the Federal Reserve charges on loans from the Federal Reserve. Not to be confused with the federal funds rate, which is the rate banks charge each other for loans that are used to hit reserve requirements. The discount rate is determined by the Federal Reserve's board of governors, as opposed to the federal funds rate, which is set by the Federal Open Markets Committee (FOMC). The FOMC sets the Fed funds rate through the open sale and purchase of U.S. Treasuries, whereas the discount rate is reached solely through review by the board of governors.

Healthy banks are allowed to borrow all they want at very short maturities (usually overnight) from the Fed's discount window, and it is therefore referred to as a standing lending facility. The interest rate on these primary credit loans is the discount rate itself, which is typically set higher than the federal funds rate target, because the central bank prefers that banks borrow from each other so that they continually monitor each other for credit risk and liquidity. 

As a result, in most circumstances the amount of discount lending under the primary credit facility is very small, intended only to be a backup source of liquidity for sound banks so that the federal funds rate never rises too far above its target—it theoretically puts a ceiling on the Fed funds rate to equal the discount rate.

Secondary credit is given to banks that are in financial trouble and are experiencing severe liquidity problems. The central bank's interest rate on secondary credit is set at 50 basis points (0.5 percentage points) above the discount rate. The interest rate on these loans is set at a higher penalty rate to reflect the less-sound condition of these borrowers. Under normal circumstances, the discount rate sits in between the Fed Funds rate and the secondary credit rate. Example: Fed funds rate = 1%; discount rate = 2%, secondary rate = 2.5%.

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