Fed Wants to Take the Discount Out of Discount Rate

The Federal Reserve has a novel idea for the money it provides in times of crisis: Make it more expensive, and maybe more banks will use it.

Addressing a problem that became especially pronounced after the Sept. 11 terrorist attacks, the Fed is proposing to set its so-called discount rate above the fed funds rate that banks charge each other for overnight loans.

Currently, the discount rate is set a half percentage point below fed funds, reflecting its historic role as a source of funds for troubled banks that need access to cheap funds.

But the discount window has another function: It's supposed to provide liquidity to healthy banks in times of widespread economic stress. That role has been crimped over the years because of the stigma and cost associated with accessing the discount rate, and it is primarily what the Fed hopes to re-establish with the current proposal.

Under the plan, the main discount rate, currently at 1.25%, would increase to 2.75%. One effect of that would be the elimination of the potential for unscrupulous banks to abuse it by borrowing at the below-market rate and marking up loans to borrowers.

While such abuses are rare, the chances of them happening at all makes it necessary for the Fed to perform costly means tests on any institution that borrows at the discount window.

The Fed proposal then calls for the creation of a third rate category, "secondary credit," set a half-percentage point above fed funds for troubled banks that needed access to cheap money.

"Adoption of the proposal would not entail a change in the stance of monetary policy," the Fed said in a press release. "The Federal Open Market Committee's target for the federal funds rate would not change as a result of this proposal and the level of market rates more generally would be unaffected."

What would be affected under the new system is the stigma that is currently attached to using the government for loans in times of legitimate financial stress.

"The one thing that borrowing from the Fed does is generate scrutiny. It sends up a flare that says, come and examine me right now," says Keith Leggett, senior economist with the American Bankers Association. Such borrowing has been shunned by healthy banks since the savings and loan crisis of the mid-1980s.

"The Federal Reserve expects that, as a result of this reduced administration, institutions' willingness to use the window when money markets tighten should increase, limiting potential volatility in the federal funds rate," the Fed said.

While the change, if approved, would make it more expensive for troubled banks to borrow money, it won't change the Fed's role as a lender of last resort, economists said.

Credit still would be available for banks that need it, only at a slightly higher cost. "By making the discount rate a punitive rate, the Fed is trying to make it a disincentive to coming to the discount window," says Christopher Low, chief economist for First Tennessee Capital Markets.

A change to the discount window's operation is unlikely to affect the overall banking business, Low says. And acceptance of the rule change is not assured. Over the next 90 days, the Fed will hear public comments on the proposed rule change to gauge what affect it would have on the system. "No one is going to go to the discount window unless the absolutely have to," he says.