The Discount Window as a Monetary Policy Tool

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The discount window is a monetary policy tool (managed by central banks) that permits genuine institutions to scrounge money from the central bank, mostly on the basis of short-term, in order to obtain fleeting paucities of liquidity, which may be caused by either internal or external intervals.

The interest that is charged by the central bank is known as the base rate, discount rate or repo rate. However, the borrower must provide collateral on such loan (Federal Reserve 1). The main idea behind the discount window is to give banks liquidity whenever they necessitate it without making them much dependent upon it. In 2007, the Federal Reserve successfully did this by decreasing or increasing the discount rate.

This means that by decreasing the discount rate, the Federal Reserve is attempting to enhance the development by making liquidity easier to be obtained, and by increasing, it indicates that Federal Reserve is worried about inflationary on the economy and that is why it is endeavoring to decrease the amount of money in the economy (Bogle 12).

What Was Happening to the Banks at That Time?

The financial crisis of 2007 was stimulated by the shortfall of liquidity in the US banking system. This caused large financial institutions in US to get themselves into hot water and even some collapsing. The financial sector was impacted by the world crisis in February, 2007.

The financial crisis was caused by the major loss which had been reported by the world’s largest bank (HSBC). The bank had lost holdings by $10.5 billion. This led to the crisis which had been compared with the Great Depression. For about 100 mortgage companies had to report about selling their activities or about their shut down throughout 2007.

As crisis continued to dig out, other financial institutions decided to merge or announce to look for merger partners. The top managers (such CEO’s) who could not bear the situation, made a decision of relinquishing their jobs, a good example is the CEO’s of Citigroup and Merrill Lynch, who relinquish within two weeks (Dozark-Frideres 1).

Moreover, this financial crisis of 2007 caused huge panic in financial markets and as a result, a lot of investors were totally discourage, hence they began taking away their money from shrinking mortgage bonds and equities and invest it in other secure ways, such as commodities as “store of value.”

However, due to overwhelming number of investors in commodities following the collapse of financial firms, the speculation of commodity has resulted to food crisis and an increase of oil prices, because of commodity super-cycle. In addition, the financial investors who are looking for fast returns have taken away trillions of money from the risky mortgage bonds and equities, making some to invest in raw materials and food (Bogle 45).

In 2006, provisions for prospect defaults and mortgage defaults influenced the income at the 8533 depository institutions of the United States. These defaults caused the decrease from $35.2 billion to $646 million by the FDIC. This resulted in a decrease of 98%. Having analyzed the financial situation in t world, it may be stated that the country’s economy has not experience such problems since 1990. 2007 was considered to be the worst year for performance for most financial firms in the country.

Turning to the problems of insured depository firms, is should be mentioned that the companies had lost about 31% in comparison with 2006. Thus, the income of the insured depository firms in 2007 was $100 billion, while in 2006 it was about $145 billion. In same year (2007), the profit decreased from $35.6 billion Q1 to $19.3 billion in Q1 of 2008, a decrease of 45% (FDIC 1). Below is a bar graph that shows the quarterly U.S. bank earnings from 2004 to 2008.

Quarterly U.S. Bank Earnings from 2004 to 2008

Quarterly U.S. Bank Earnings from 2004 to 2008

Furthermore, there was a situation when the discount window became the same as the federal fund rate. This situation became possible due to the fact that the supply curve of reserves became horizontal. This was provoked by the Fed desire to offer as many loans as possible at the discount rate to prevent them from bankruptcy.

There was a situation in 2007 when discount rate and the federal fund rate equaled each other. This situation became possible in a number of reasons. “As i_ff rises above i_d, banks will borrow more and more at i_d, and re-lend at i_ff. The supply curve is horizontal (perfectly elastic) at i_d (Wright and Quadrini n.p.).

The situation is showed below.

Equilibrium in the fed funds market

Table 1. Equilibrium in the fed funds market (Wright and Quadrini n.p.)

It is possible to consider the situation when the discount rate and the federal fund rate equaled each other: on the 16^th of March, 2008 the discount rate was cut 25 bps and was reduced to 3.25% and indicated an intermeeting move (Chronology n.p.).

What Was Happening to the Economy?

The economy of the United State of America was also in hot soup. Betwixt June 2007 and November 2008, it was report that Americans lost approximate a quarter of their net value. The prices of house had decline to 20% from their peak in 2003, while other prospect markets indicating a potential decline of 30 to 35%. By mid-2008, the US total home equity decline to $8.8 trillion for its peak in 2006 that valued at $13 trillion. To understand the level of the problem, it is important to consider the activities from a broad U.S. stock index.

The decline in November 2008 was 45% if to calculate from the peak in 2007. The declination of the total retirement assets from 2006 to 2008 was about 22% (in 2006 the numbers reached $10.3 trillion, and in 2008 the activities hardly reacted $8 trillion). Meanwhile, the investments and the savings made a loss of $1.2 trillion. At the same time, a loss of $1.3 trillion was considered in the activities of the pension assets (Dozark-Frideres 1). Below is a graph showing US housing price performance from 1998 to 2007.

US house price trends

How the Discount Windows Usually Operate

To save the situation, or at least do not support its further damaging development, the Federal Reserve Bank have created three different discount window programs. These discount window programs were directed at depository institutions. “Primary credit, secondary credit and seasonal credit” (Federal Reserve 1) are the discount window programs implemented by the Federal Reserve Bank.

However, although all credits are fully secured, each credit has its own rate of interest. In the primary credit program, loans are normally prolonged for a short term (for about 24hrs) to depository firms in order to meet the financial conditions.

For the financial firms that are not under primary category can apply for secondary credit so that they can settle their severe financial problems or short-term liquidity necessities. On other hand, seasonal credit is prolonged to comparatively small depository firms that have persistent intra-year ebb and flow in funding necessities, like seasonal resort communities or banks in agriculture.

Now, it is important to consider the discount rate charges in the primary credit, in the secondary credit, and in the seasonal credit. Turning to the primary credit, the charges are more than the normal level of short-term market interest rates. Using the secondary credit, the charges are going to be above the primary credit.

Using the seasonal credit, the charges are going to be set on an average of certain chosen market rate. The depository institutions had an opportunity to choose the discount window program depending on the conditions of each offer. The discount rates have been formed by every Reserve Bank’s board of directors (Federal Reserve 1).

How Did It Exactly Operate in 2007?

In the response, the USA central bank together with central banks across the globe and the Federal Reserve took several measures to address the crisis. Below is how the discount window operated in 2007.

The discount rate was decreased from 5.75% (August) to 4.75% (December), and the Federal funds rate was also lowered from 5.25% (August) to 4.25% (December).
They also formed lending institutions, which offered loans with low collateral to banks and other financial firms.

The financial institutions were encouraged to apply for loans, either under primary, secondary or seasonal credit, but this depended on their qualification (Dozark-Frideres 1).

Did the Discount Window Continue to 2008 and Why?

The discount window programs continued in 2008. Here are a number of reasons for such decision. The main reason for extending discount window in 2008 was the fact that still many financial institutions had not fully recovered from this crisis. In December 2008, the Federal Reserve decreased the federal funds rate further to a range of 0-0.25%. Moreover, in November 2008, the Fed said that it wanted to purchase MBS of the GSE at a price of $600, in order to decrease the mortgage rates (Dozark-Frideres 1).

The Federal Reserve Bank could not leave unstable financial situation in the country without support, so the decision was made to continue the discount window programs up to the time when the financial stability is implemented in the world bank system.

What Does the Discount Window Do With Sterilized Funds in the Federal Reserve?

The discount window can open market operations, whereby it venders bonds domestically, hence gaining new cash that can go around the home economy (Federal Reserve 1). Moreover, according to the Federal Reserve, “U.S. branches and agencies of foreign banks that hold reserves are eligible to borrow under the same general terms and conditions that apply to domestic depository institutions” (Federal Reserve 1).

Why Did Not the Federal Reserve Allow Lehman Brothers to Use the Discount Window in 2007?

The Federal Government did not want to bail out Lehman brothers, as it had had already drawn the line somewhere, and other financial firms could not stay connected with Lehman assets on the spot (Siris 1). At the same time, many financial institutions “could not get comfortable with Lehman’s assets in an instant” (Siris 1).

Federal Government hoped that Lehman had enough assets to recover from crisis and stabilize the situation. The theoretical ability of Lehman to keep the company afloat was one of the main reasons why it was refused in discount window program. Still, the firm suffered more than it was expected and there was a threat Lehman’s bankruptcy impacted each organization at the Wall Street (Siris 1).

In conclusion it should be stated that discount window programs provided by the Federal Reserve Bank were effective and they made it possible for many different companies remain afloat. At the same time, the inability of the programs to fund each organization and cover the expenses or each company made the Federal Reserve Bank draw the line which did not satisfy the expectations of many financial institutions at the Wall Street. But, in general, the activity was successful.

Works Cited

Bogle, John. The Battle for the Soul of Capitalism. London: Yale University Press. 2005. Print.

“Chronology – Fed funds rate changes since 1994.” Reuters. June, 2010. Web.

Dozark-Frideres, Taryn. How Did the Central Banks in the U.S. and Europe React to the Global Financial Crisis? 2010. Web.

FDIC. FDIC Quarterly Banking Profile. 2008. Web.

Federal Reserve. The Federal Reserve Discount Window. 2010. Web.

Siris, Peter. Government Did Not Want To Bail Out Lehman Brothers. 2008. Web.

Wright, Robert E. and Vincenzo Quadrini. Money and Banking. Irvington, NY: Flat World Knowledge 2009. Web.

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