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Thursday, March 31, 2011

Why Do Central Banks Have Discount Windows?

The names of the banks that borrowed from the Fed during the financial crisis will be released today by court order. It's probably just a coincidence that this post on the history of the discount window and the stigma of being identified as needing to use it appeared on the new blog from the NY Fed:

Why Do Central Banks Have Discount Windows?, by João Santos and Stavros Peristiani, Liberty Blog: Though not literally a window any longer, the “discount window” refers to the facilities that central banks, acting as lender of last resort, use to provide liquidity to commercial banks. While the need for a discount window and lender of last resort has been debated, the basic rationale for their existence is that circumstances can arise, such as bank runs and panics, when even fundamentally sound banks cannot raise liquidity on short notice. ... In this post, we discuss the classical rationale for the discount window, some debate surrounding it, and the challenges that the “stigma” associated with borrowing at the discount window poses for the effectiveness of the discount window. ...
Stigma

While the discount window is an important tool for central banks dealing with liquidity problems that may threaten financial stability, its effectiveness depends critically on the willingness of banks to borrow from central banks. Banks are often reluctant to borrow from central banks not only because this source of liquidity tends to be expensive but also because of the “stigma” that is associated with discount window borrowing. ...
If a bank worries that borrowing from the discount window will lead other banks to doubt its fundamental solvency, it may avoid the discount window even if the discount window provides the cheapest funds available.  Instead, the bank may liquidate marketable assets or try to borrow in the interbank market at onerous terms, further straining these markets and making it even more difficult for other banks to obtain funding or sell assets.  Thus, central banks typically disclose only a limited amount of information about discount window activity to avoid branding healthy (but illiquid) banks as weak.  The Federal Reserve, for example, has historically published the total amount of borrowing from the discount window on a weekly basis, but not information on individual loans.[1]  By allowing banks to borrow confidentially, this policy aims to make healthy institutions more willing to use the discount window during periods of market stress. It should be emphasized that confidentiality is not meant to protect the identities of individual banks per se, but rather to make the discount window more effective in dealing with market disturbances.
Central banks have long recognized the challenges that stigma creates for the effective operation of the discount window during crisis. Donald Kohn, former Vice Chairman of the Fed, has discussed the stigma problem in past speeches. “The problem of discount window stigma is real and serious. The intense caution that banks displayed in managing their liquidity beginning in early August 2007 was partly a result of their extreme reluctance to rely on standard discount mechanisms,” Kohn noted in a 2010 speech.  In fact, the need to mitigate stigma influenced the design of some of the lending facilities, such as the Term Auction Facility, created by the Fed during the financial crises.[2]
In sum, the discount window is a vital tool to maintain the uninterrupted functioning of the banking system, but its effectiveness may be limited by the stigma associated with using it. This explains why policies that aim at dealing with the stigma of discount window borrowing are so important. Admittedly, the existence of the discount window may create some moral hazard, but of course, the Federal Reserve limits moral hazard by restricting discount window access to depository institutions that are closely regulated and supervised by federal banking authorities.

    Posted by on Thursday, March 31, 2011 at 12:15 AM in Economics, Monetary Policy | Permalink  Comments (9)


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