The Fed’s New Discount Window and Interbank Borrowing

The Federal Reserve’s new primary credit facility offers guilt-free overnight loans to commercial banks at a rate of 100 basis points over the target federal funds rate. If utilized freely by the market, the facility places an upper bound on the rates at which financial institutions lend to one another overnight, reducing the volatility of the daily effective federal funds rate. Conceivably, however, banks may continue to perceive a stigma from borrowing from the Fed, and thus borrow less than what one might expect, potentially reducing the facilities effectiveness at reducing interest rate volatility. By contrast, routine use of the facility might decrease a bank’s incentive to participate actively in the interbank market. Thus, the mere availability of primary credit may lead to its use being more than what would be expected based on the historical characteristics of the interbank market. We develop a model demonstrating these two alternative market reactions to the new credit facility. A comparison of data from before and after recent changes to the discount window suggests continued reluctance to borrow from the Fed. This project could not have been undertaken without the invaluable assistance of Kurt Johnson and Jamie McAndrews at the Federal Reserve Bank of New York. The views expressed are those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.