What is the Federal Discount Rate?

What is the Federal Discount Rate?

The federal discount rate is the rate of interest paid by financial institutions to borrow overnight reserve funds from the Federal Reserve’s lending facility, also called the discount window. This is separate from the federal funds rate, the interest rate banks charge each other for overnight reserve funds.

 The Federal Reserve requires banks and other financial institutions to hold a certain amount of money in reserves at the end of each business day to ensure customers can access their funds and to protect against bank failures.

This is referred to as the reserve requirement. The reserve requirement is approximately 10 percent of the deposits made at a financial institution. For example, if a bank has deposits of $100,000,000, the bank’s overnight reserve requirement would be roughly $10,000,000.

If a bank is short on reserves at the end of the business day, they must borrow funds to meet the reserve requirement. Banks typically borrow additional overnight funds from each other, but if for some reason a bank is unable to borrow from other institutions, it must borrow from the Federal Reserve’s discount window.

There are three types of discount rates: primary, secondary, and seasonal. Most banks borrow at the primary rate, which is a short-term loan for stable institutions. Banks in a difficult financial condition are required to borrow at the secondary rate. The seasonal rate is primarily for smaller, community-focused banks that have fluctuating needs over the course of the year. These banks may serve college communities with a seasonal influx of students or a resort community with seasonal changes in population.

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The Federal Open Market Committee (FOMC) meets eight times a year and sets the the federal funds rate, depending on the needs of the economy. The Board of Governors of the Federal Reserve sets discount rates that are in line with the federal funds rate.

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How the Federal Discount Rate Works

In addition to its other monetary policy and regulatory tools, the Fed banks can lend directly to member banks and depository institutions. This is part of the primary purpose of the Fed as a lender of last resort to ensure the stability of the banks and the financial system in general. To prevent undue bank failures, healthy banks are allowed to borrow all they want at very short maturities (usually overnight) from the Fed’s discount window, and it is therefore referred to as a standing lending facility.

Under normal circumstances, banks prefer to borrow from one another on the overnight lending market. However, banks that face increased liquidity needs or heightened risks are sometimes unable to raise the necessary funds in the open market. Once the interbank overnight lending system has been maxed out, Fed discount lending serves as an emergency backstop to provide liquidity to such banks in order to prevent them from failing.

Borrowing from the central bank is a substitute for borrowing from other commercial banks, and so it is seen as a last-resort measure. The interbank rate, called the Fed funds rate, is usually lower than the discount rate. As long as the Fed funds rate is lower than the discount rate, commercial banks will prefer to borrow from another commercial bank rather than the Fed. As a result, in most circumstances, the total amount of discount lending is very small and intended only to be a backup source of liquidity for sound banks.

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Federal discount rate example

Investment bank Pierce & Pierce has seen several of its energy sector deals go sour in the ongoing oil price collapse. These developments have sapped capital from the firm and made it challenging to meet its reserve requirements.

Moreover, an emerging financial crisis is starting to impact the United States financial sector, and Pierce & Pierce finds that it cannot borrow funds at a reasonable rate from another bank to meet its overnight reserve requirements. These difficult circumstances would force the firm to borrow from the Federal Reserve’s discount window.

The Discount Rate and Monetary Policy

Beyond its role in preventing bank failures, the federal discount rate is used as a tool to either stimulate (expansionary monetary policy) or rein in (contractionary monetary policy) the economy.

A decrease in the discount rate makes it cheaper for commercial banks to borrow money, which results in an increase in available credit and lending activity throughout the economy. Conversely, a raised discount rate makes it more expensive for banks to borrow and thereby diminishes the money supply while retracting investment activity.

Besides setting the discount rate, the Fed has several other monetary policy tools at its disposal. It can influence the money supply, credit, and interest rates through open market operations (OMO) in U.S. Treasury markets, and by raising or lowering reserve requirements for private banks.

The reserve requirement is the portion of a bank’s deposits that it must hold in cash form, either within its own vaults or on deposit at its regional Fed bank. The higher the reserve requirements are, the fewer room banks have to leverage their liabilities or deposits.