- Key insight: Industry stakeholders say reducing operational barriers and concerns about stigma will be key to making the discount window a more viable funding source for banks going forward.
- Expert quote: "I think the problem with both the discount window and the liquidity rules as they stand right now is like what Churchill said: It's the worst system, except for all the others." — Graham Steele, former assistant secretary for financial institutions at the Treasury Department and an academic fellow at the Rock Center for Corporate Governance at Stanford Law School.
- What's at stake: The Fed's discount window has long been underused, in part because banks fear market backlash. Regulators are exploring changes that could reduce the stigma and make emergency borrowing more straightforward.
WASHINGTON — Fed watchers say a proposed revamp of the discount window would be a welcome development, as the tool has both operational and reputational shortcomings that make banks reluctant to use it, even in times of stress.
The discount window allows member banks to obtain emergency liquidity quickly in exchange for certain securities, and is designed to allow banks to shore up their finances during periods of financial strain. But because the window, known as the "lender of last resort," implies banks might not be able to obtain liquidity otherwise and thus may be in danger of insolvency, banks tend to avoid using it unless they absolutely have to — and by that point, it can be too late.
Stakeholders say the clunky lending system and banks' historical reluctance to use the discount window has rendered the window ineffective. But Graham Steele, a former assistant secretary for financial institutions at the Treasury Department and an academic fellow at the Rock Center for Corporate Governance at Stanford Law School, said the inefficiencies around the rules and processes around obtaining emergency liquidity have been acceptable to regulators and the market because they are well understood, and that replacing the system with another that stakeholders trust will be tricky.
"I think the problem with both the discount window and the liquidity rules as they stand right now is like what
Modernization and operational hurdles
The conversation around the central bank's discount window reemerged earlier this week after Federal Reserve Vice Chair for Supervision Michelle Bowman and Treasury Secretary Scott Bessent, in separate comments,
Bowman said the discount window needs "fundamental reform," including streamlined rules and processes across the Fed's 12 regional reserve banks. She said variations in procedures create "uncertainty for borrowers" and could "exacerbate fragilities in the banking system."
Meanwhile, Bessent suggested regulators allow banks to count some borrowing capacity at the Fed's discount window toward their liquidity requirements, provided collateral is already pledged, which could simplify getting access to liquidity in times of stress.
A string of
Stakeholders say ease of access to the Fed's discount window and consistent rules among all 12 regional banks are areas the Fed should consider when thinking about reform. The current infrastructure has been
Susan McLaughlin, executive fellow of Yale University's Program on Financial Stability and former staffer at the Federal Reserve Bank of New York, said that any reform efforts must be centered on modernizing and streamlining the lending process.
"The Fed talks a lot about direct access. All that direct access does, as far as I understand right now, is allow firms to submit loan requests automatically," she said. "It doesn't automate the approval of the loans. It doesn't do anything to speed up the collateral allocation process, to the extent that they don't already have enough collateral pre-positioned. There are definitely opportunities there."
McLaughlin, who once oversaw the New York Fed's discount window, said the bank failures of 2023 highlighted that some institutions did not fully understand what collateral they could use to access the facility. Signature Bank "didn't have the discount window as part of their contingency plan," and access wasn't tested in years, she said. Meanwhile, Silicon Valley Bank didn't fully understand how to move collateral to the reserve bank.
Stakeholders say this could be addressed by requiring banks to test their discount window access annually. Bessent's idea of pre-positioning collateral could also help banks access liquidity more quickly in times of stress, said David Zaring, associate professor at the University of Pennsylvania.
"By introducing that, the Fed is trying to make it so banks aren't self-insuring totally on liquidity, and that they can self-insure up to a cap, but then use discount window capacity positioned at the Fed to make up any shortfall," he said.
Addressing negative perception
The most notable issue cited with the Fed's discount window is the negative market perception associated with using it. Banks operate based on a presumption of strength, and if using the window is perceived as a sign of trouble, it could make a difficult situation worse for a bank that uses it.
McLaughlin said a history of mixed messaging from the Fed — whether the discount window is a routine liquidity tool or something banks should avoid — has contributed to the perception problem.
Both Bowman and Bessent cited market reactions to any usage by banks as a sign of fragility.
"It's a really thorny issue: How do you get market participants to reorient the way they think during times of stress, and what banks are supposed to do in that moment, and the banks' own incentives to dip into their own liquidity buffers or tap the discount window when they really need to," Steele said.
One way to reduce the negative perception, Zaring said, is to require banks to regularly borrow from the discount window in small amounts.
"That would be a way of lessening the negative signal, because there'd be a regulatory requirement that banks regularly access it in small amounts," he said. "It could get banks and reserve banks comfortable with discount window borrowing."
McLaughlin also suggested changing the name of the Fed's facility entirely.
"Don't call it a discount window. Don't call it primary credit or secondary credit, or a lender of last resort. Call it a liquidity provision, because that's really what it is," she said.
Banks preferring home loan banks
Part of the challenge in reforming the discount window is that it is not the only liquidity facility out there — or even the primary one that banks turn to in times of stress. Banks instead routinely turn to the Federal Home Loan banks when they're in a pinch.
Banks often prefer borrowing from the Federal Home Loan banks because the borrowing rates are lower, it carries less stigma and can be easier to access.
"Banks get some rebates from the FHLBs or dividends back from them, such that they end up with, effectively, a subsidized rate for borrowing that is different from the ostensible penalty rate they're supposed to get from the discount window itself," said Steele, who was serving as under secretary for domestic finance at the Treasury Department during the 2023 banking crisis. "So there's an implicit subsidy there to borrow from them."
Steele added that it "bedeviled" him and his colleagues that Silicon Valley Bank and other institutions chose to go to the Federal Home Loan banks over the discount window in the months leading up to their failure.
"One of the results of that experience was that these banks were not set up to borrow from the Fed when they got shut off from their Federal Home Loan bank," Steele said.
Some industry stakeholders view the Federal Home Loan banks as limiting the Fed's ability to encourage broader use of the discount window.
"[The FHLBs are] keeping the Fed from having more banks use the discount window," said Cornelius Hurley, professor of financial services law at Boston University. "Instead, there's what I call ambient noise."
McLaughlin said the relative ease of borrowing from the Home Loan banks makes banks think less — if ever — about using the discount window, and that neglect becomes a self-perpetuating cycle.
"I think the problem is that by relying on FHLBs, the way that Signature Bank did, they completely neglected the role of the Fed and being prepared to use that tool when they needed to," McLaughlin said. "It's just not helpful."
But Bowman does not seem to agree.
"It is critically important that where we have banks that need to move collateral from the Federal Home Loan banks to the discount window, there is a process that allows for that to happen seamlessly and quickly," Bowman said. "Generally, if you're moving from FHLBs to the discount window, it's because you're experiencing some stress."
Ryan Donovan, president and CEO of the Council of Federal Home Loan Banks, highlighted that the FHLBs and the Fed "play complementary roles in providing liquidity.
"We are closely coordinating to improve interoperability, particularly in times of crisis," Donovan said. "We believe any reforms to the discount window should preserve, not devalue, the essential, complementary liquidity that the FHLBanks provide."
But Zaring said the Fed has the obligation to think of the broader financial system when it lends out liquidity to troubled institutions, whereas the Federal Home Loan banks — which have priority in having their advances repaid if a bank fails — may not have in the same way.
"The problem with FHLBs as a second lender of last resort is it's not clear that they really care about who they lend to because of what their liquidity or solvency situation looks like, because the FHLBs have a huge priority in getting repaid for their advances," Zaring said. "That means, essentially, they can lend this money out risklessly, and that means they don't really care who they lend it out to."
