Federal Reserve Discount Policy

In my readings on the Federal Reserve, I have come across some things that may make others understand how the big banks exercise control over them. The discount policy in my opinion provides some insight into this. I need to give some background information first so that my points are understood and will discuss the points that are in bold later on.

BACKGROUND INFORMATION:

The discount window is a tool used by the Federal Reserve which allows commercial banks and other depository institutions to borrow at the discount rate to meet their reserve requirements. The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility.

The Fed has three programs for depository institutions – primary credit, secondary credit and seasonal credit programs.

1.      Primary credit

Typically primary credit is given on a short-term basis (overnight) to depository institutions that have strong financial positions and ample capital. Companies that qualify for primary credit do not need to exhaust other sources before using the discount window.

Eligibility for primary credit is based on the borrower’s examination ratings and capital. Supplementary information (including market-based information) can also be used. Primary credit ordinarily is extended at a rate 100 basis points above the federal funds rate with minimal administrative costs. So there are no checks and balances. I will try to explain what this rate exactly means in another post.

The Fed can extend primary credit for up to a few weeks as a backup source of funding. But if the institutions want longer-term extension of this credit then they will be subjected to more administrative requirements.

2.      Secondary credit

This is offered to institutions that do not qualify for primary credit. This too is available as a backup source of funds on a short-term basis. There are however greater administrative requirements because the borrower does need to provide proof that they can meet the terms of the loan. As of January 2003, the discount rate on secondary credit rates was 50 basis points above the federal funds rate. As with primary credit, longer-term secondary credit is also available.

3.      Seasonal credit programs

The only institutions that qualify for this are small to mid-sized depository institutions that clearly show intra-year fluctuations in funding needs. Agricultural communities are primary users of seasonal credit programs.

Discount window loans are secured by collateral that exceeds the amount of the loans.

Under extremely rare circumstances a Reserve Bank can give advanced credit to individuals, partnerships and corporations that aren’t depository institutions but they have to consult with the Board of Governors beforehand.

MY THOUGHTS:

The information above does provide a little insight into how the Federal Reserve caters toward the banks:

- Regarding the different types of credit programs: There are different qualifications for each program. The primary credit one is geared towards institutions with "strong financial capital" - this includes the banks. The fact that Primary credit is extended with "minimal administrative costs means that there are no checks and balances. If there were, then the administrative costs would increase. To me this indicates that they do not have to show proof of whether or not they need the money that the Fed lends them. However, those who qualify for the secondary program instead of the primary one need to produce more proof that they need the money that the Fed will lend them, despite the fact that they do not have as much capital as the banks.

-Conditions under which the Fed can give advanced credit: The last sentence "Under extremely rare circumstances a Reserve Bank can give advanced credit to individuals, partnerships and corporations that aren’t depository institutions but they have to consult with the Board of Governors beforehand" also basically states that they can lend money to the banks without having to prove whether or not they need the money. "Reserve Bank" are banks that belong to the Federal Reserve. The big banks of course are depository institutions, so they do not have to ask permission to obtain money.