Discount Window Lending

Definition

The term discount window refers to the process of going to the Federal Reserve to borrow money on a short-term basis. The discount window is one of the three tools the Federal Reserve can use to reach their monetary policy objectives.

Explanation

Back in 1913 when the Federal Reserve System was established, the discount window was the primary mechanism for conducting central banking operations. The term is a reference to the long-gone practice of a commercial bank representative visiting a reserve teller window to borrow money. Today, open market operations is the primary tool used by the Federal Reserve to achieve their monetary policy objectives. The discount window now serves as a fallback option when a depository institution needs an extension of credit to meet their reserve requirement.

Generally, financial institutions are reluctant to borrow at the discount window since it will be seen by the marketplace as a sign of a liquidity problem. The discount rate is the rate of interest charged for short-term loans made by the twelve Reserve Banks to commercial banks at the discount window. There are three different discount lending programs:

  • Primary Credit: the rate of interest is typically higher than other short-term interest rates like the fed funds rate. Commercial banks borrowing at primary credit are generally in good financial condition.
  • Secondary Credit: banks that do not qualify for primary credit can apply for a secondary credit loan. These banks are typically having financial difficulties and need short-term liquidity. The rate of interest on these loans is higher than that charged for primary credit loans.
  • Seasonal Credit: banks serving seasonal customers, such as those in agricultural communities, can apply for a seasonal credit loan. These loans are typically limited to small depository institutions that have a recurring intra-year funding need. The rate of interest charge for seasonal credit is an average of selected market rates.

During a credit or liquidity crisis, the Federal Reserve's Board of Governors can authorize a fourth category of lending known as emergency credit. This credit facility can only be offered when a participant is unable to secure credit from other banking institutions. Loans under this program need the approval of at least five of the seven members of the Board of Governors. 

Related Terms

quantitative easing, repurchase agreement, reverse repurchase agreement, discount rate, System Open Market Account