The Federal Reserve discount window is a lending facility that allows eligible depository institutions (such as banks and credit unions) to borrow funds from the Federal Reserve to meet short-term liquidity needs.
The discount window operates as follows:
- Eligibility: First, an institution must be eligible to borrow from the discount window. Generally, banks and credit unions that are chartered by the federal or state government and are members of the Federal Reserve System are eligible to borrow from the discount window.
- Collateral: To borrow from the discount window, an institution must pledge collateral to the Federal Reserve. The type of collateral that is eligible depends on the program and is subject to certain limitations and haircuts. Collateral could include securities such as Treasury bonds, agency bonds, or mortgage-backed securities.
- Discount Rate: The Federal Reserve sets the discount rate, which is the interest rate at which eligible institutions can borrow funds from the discount window. The discount rate is typically higher than the federal funds rate (the interest rate at which banks lend to each other overnight), but the Federal Reserve may adjust the discount rate based on economic conditions.
- Borrowing: If an eligible institution needs to borrow funds from the discount window, it can contact its local Federal Reserve Bank to initiate the borrowing process. The Federal Reserve Bank will determine the amount of funds that the institution is eligible to borrow based on the value of the collateral pledged and other factors.
- Repayment: Discount window loans are typically short-term, with maturities ranging from overnight to 90 days. The borrowing institution must repay the loan by the maturity date or seek an extension from the Federal Reserve.
The discount window is an important tool for the Federal Reserve to manage the liquidity of the banking system and to provide support during times of financial stress. However, borrowing from the discount window can be seen as a signal of financial weakness, so institutions typically try to avoid borrowing unless absolutely necessary.
Source: Federal Reserve, TC