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1 1 (May 8, 2024)

handle is hein.crs/govepbn0001 and id is 1 raw text is: Con re sY~n I flesedrch Service horujig Aecj have le a~m 'e1914 May 8, 2024 Federal Reserve's Discount Window: Policy Issues The failure of three large banks in the spring of 2023 put the discount window (DW) of the Federal Reserve (Fed) back in the spotlight. DW lending suddenly spiked, reaching an all-time high of $295.7 billion. This In Focus discusses policy issues raised by this episode. Congress has focused on the DW in its oversight capacity, as evidenced by a recent House hearing. Background The Fed was created in 1913 in response to a perceived need for a lender of last resort (LOLR). The Fed fills this role by making short-term loans to depository institutions, such as commercial banks, through its DW. Typically, the Fed's LOLR operations are minimal because banks can borrow privately. But during periods of financial instability, such as the 2007-2009 financial crisis and the COVID-19 pandemic, DW lending grew rapidly as private sources of liquidity dried up. To borrow from the DW, banks pledge assets as collateral, temporarily converting illiquid assets into liquid reserves. Banks that are adequately capitalized and are not poorly rated by their supervisors use primary credit and can borrow for up to 90 days with no questions asked. Poorly capitalized or rated banks must use secondary credit, which is shorter term and subject to close oversight. Seasonal credit is also available for small banks to manage seasonal inflows and outflows. The Fed sets the discount rate charged for loans. Traditionally the primary credit rate was set above market rates, but since the pandemic it has been set at the top of the federal funds rate target range. The secondary credit rate is still higher. In addition to the limits on secondary credit, risks to the Fed are minimal because loans are short term, must be repaid even if collateral loses value, and are backed by assets worth more than loan value. Polcy kSues St gma An effective LOLR is one where banks do not use the DW in normal conditions and readily use it in times of financial stress. Although DW lending has ramped up in crises, policymakers express concern that stigma associated with the DW reduces its use. Stigma may create reluctance to borrow from the DW because depositors or other creditors will view this as a signal that the bank is troubled and run on the bank-a fear that is most likely to manifest during stress periods when usage is desired. If true, stigma makes the DW less effective at mitigating systemic risk. The Fed discouraged DW use in normal conditions until 2003, when it reformed DW operations partly to reduce stigma by removing moral suasion and by making loan approval easier. The Fed now states that primary credit can be obtained no questions asked for any purpose, including arbitrage opportunities, such as to lend for profit. Nevertheless, concerns about stigma remain. Despite official policy, almost 40% of surveyed domestic banks said supervisory disapproval made them reluctant to use the DW. The Fed has promoted the idea that there should be no stigma, but it has also tacitly acknowledged that stigma exists by creating various untainted alternative lending facilities and by convincing large banks to publicly announce borrowing from the Fed during crises. Stigma could be reduced by making DW borrowing confidential, which it was until the 2010 Dodd-Frank Act (P.L. 111-203) required the identities and terms of borrowing to be publicly disclosed with a two-year delay. Three-quarters of surveyed banks said these disclosures discouraged them from using the DW. Lending to Faihng Banks Banks can fail because they are illiquid (they cannot access cash) or insolvent (their assets are worth less than their liabilities). The DW is meant to protect illiquid-not insolvent-banks, which arguably did not occur in 2023, as three banks borrowed from the DW and failed anyway. DW lending to problem banks is meant to be limited because they may use it to gamble for resurrection. Yet the three large banks that failed in 2023 remained eligible for primary credit until shortly before their failures. Post- mortem regulator reports found that examiners did not downgrade them as quickly as they should have: All three were considered well capitalized by regulatory standards until they failed. Although Silicon Valley Bank (SVB) and Signature failed very suddenly and unexpectedly, First Republic's failure was more drawn out, and it was able to borrow $109 billion through primary credit after experiencing depositor runs that made its weakness a high- profile story. It remained eligible for primary credit until three days before its failure when the FDIC downgraded its supervisory rating. Although all DW loans to the failed banks were fully repaid, the episode nevertheless raises concerns about the effectiveness of limitations on lending to failing banks. It is unclear whether the loans increased or reduced risk to the taxpayer, notably in the case of First Republic. DW lending might have delayed its inevitable failure, and resolving banks at least cost typically requires a failing bank to be resolved as soon as possible. Alternatively, DW loans may have reduced costs by allowing for its more orderly resolution, in contrast to SVB and Signature, which required emergency guarantees of uninsured deposits.

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