Discount Rate Essay

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One definition of a discount rate is the interest  rate the U.S. Federal Reserve (or another  central  bank) charges on loans to banks through the discount window. The establishment  of the U.S. Federal Reserve System in 1914 was to  provide  a source  of funds (reserves) from  which  commercial  and  depository institutions can borrow in case of a temporary shortage. The discount window is the mechanism through which each of the 12 regional U.S. Federal Reserve banks lends to commercial  and depository  institutions. Another  definition of a discount  rate is as an investor’s opportunity cost  of funds. It is the  best return an investor can earn on investments given the risk of such investments.  The borrowing rate is also referred to as a discount  rate. In the money market for securities,  where securities  are issued at a discount  from par (face) value, discount  rate refers to the rate of return  on a security.

The U.S. Federal Reserve (Fed) serves as the lender of last resort. When banks and depository institutions face temporary  shortage  of funds  they can borrow from the Fed through  the latter’s  discount  window.

The Federal Reserve originally limits discount window loans to discount  or rediscount  activities for members of the Federal Reserve System. Thus, a borrower sells “eligible paper,” such as agricultural  loan documents  supporting  a loan to a customer  to a Federal Reserve Bank. The Federal Reserve Bank in turn provides credit in the amount of the discount in the borrowing bank’s account. Once the loan is paid, the Fed returns  the “eligible paper” and makes a debit entry in the reserve account  of the bank. Over the years, discount window loans were dominated  by advances, which are loans secured by approved collateral. Such loans are paid back with interest at maturity.

In 1980, after the passage of the Depository Institutions Deregulation and Monetary Control Act (DIDMCA), discount  window loans were extended  to all depository institutions  including banks that are nonmembers of the Federal Reserve System. In “unusual and exigent circumstances,” individuals, partnerships, and corporations that are not depository institutions can take advantage of the discount window opportunities subject to approval of the Board of Governors of the Federal Reserve System.

Traditionally,  the  Fed extends  discount  loans  to depository   institutions    through    three   programs: (1) adjustment   credit,  (2) seasonal  credit,  and  (3) extended credit. Adjustment credit loans are the most common and they are given to cover temporary needs for funds arising from deposit  outflow. These loans can be obtained with telephone calls to a regional Fed. Repayment of such loans is made fairly quickly, from a day to a few days for large depository institutions. Seasonal credit is extended to small institutions  that depend  on  seasonal  activities such  as farming  and tourism. The borrowing institutions  also have limited access to national money markets. An extended credit can be granted to a depository institution facing special liquidity difficulties. A group of institutions  can be given extended credit if they face deposit outflows because of changes in the financial system, such as natural  disasters  or other  difficulties that  are common to the borrowing institutions.  The repayment of extended  credit  takes time. A borrowing  institution needs to provide a proposal  that  outlines  a call for credit and how and when the liquidity position of the institution will be restored. A good example involves Franklin National Bank, which borrowed about $1.75 billion from the Fed in 1974.

In January 2003 the Board of Governors of the Fed authorized  the Federal Reserve Banks to operate the following revised discount window programs: (1) Primary Credit, (2) Secondary Credit, and (3) Extended Credit.  The  new  primary  credit  program  involves loans that are extended for a very short term (generally on overnight basis) to depository institutions that are adjudged  to be financially sound.  The discount rate on primary credit is set above short-term market interest rates that include the federal funds rate. Borrowing institutions  of short-term primary credit are not required to have exhausted other sources of funds before participation  in the  discount  window activities. Each borrowing  institution must  meet the collateral policies as specified in the Federal Reserve Act. Those depository institutions  that are not eligible for primary credit can apply for secondary credit to meet short-term liquidity needs or to resolve severe financial difficulties. Participation  in the secondary credit program  is contingent  on a timely return  to reliance on private funding sources. In the case of a severe difficulty, the Federal Reserve Bank in cooperation  with the  Federal  Deposit  Insurance   Corporation  must agree that  granting  secondary  credit  is a least-cost resolution  of the  problem.  Seasonal credit  is available to small and medium-sized  depository  institutions  that  experience  significant seasonal swings in their loans and deposits. Seasonal credit should help to address recurring interlayer fluctuations in funding needs of small banks in agricultural or seasonal tourism communities.

In general, changes in the discount  window loan rate occur infrequently.  The lowest discount  rate in history was 0.5 percent from 1942 through 1946. The highest  rate  was 14 percent  in  1981. The primary credit discount rate has varied from 2 percent to 6.25 percent  from  2003 through  mid-2008.  In  order  to stem the growing problems within the U.S. financial system, the Fed began a spate of cuts in the discount rate since August 2007.

Discount Rate Policy

As a part  of its monetary  policy mandate,  the  Fed controls the volume of discount loans in two ways: By controlling  the price of the loan (discount  rate) and by controlling  the quantity  of the discount  window activities. Through  its power over discount  window activities, the Fed can influence the money supply in the  economy.  For example, an increase  in discount loans leads to an increase in bank reserves and consequently an expansion of money supply. Conversely, a decrease in the volume of discount  loans leads to reduction  in money supply.

Based on the foregoing, the discount  window can be used to influence the reserves of depository institutions. Another  important function  of the discount policy is its implied announcement effect. A change in the discount rate is perceived as a signal of the Fed’s future direction  in terms of monetary  policy. Unlike some  other  monetary  policy instruments, the  discount rate is used irregularly. When a change is made in the direction of the movement of the discount rate, the public often interprets this as a signal of the thinking of the  Fed’s Board of Directors  concerning  the future course of monetary policy.

An increase in the discount  rate after a series of reductions may indicate that the board foresees impending  inflationary pressure. In order to control this, the Fed makes it harder to get credit in the near future. There may be a problem with the interpretation  by the public of Fed’s intentions.  For example, when market  interest  rates are increasing relative to the discount rate, the volume of discount loans tends to rise as well. The Fed may increase the discount rate just to keep it in line with market interest rates without necessarily changing its policy to be less expansionary. Bankers may see this development as an indicator of a potential shortage of reserves and react by slowing down loan commitments.

A significant advantage  of the  discount  policy is that it allows the Fed to perform  its function  as the lender of last resort. Historically, the performance  of this function has provided some stability to the financial sector. The notable cases of the use of the discount window include the rescue of Franklin National Bank in 1974, Continental Illinois National  Bank in 1984, and in September  2007, the Fed announced  a huge cut in both  the federal funds rate and the discount rate in order to facilitate borrowing by America’s largest banks. This was considered necessary to facilitate the bailout of their affiliates and other operators, such as hedge funds, caught in the subprime loans crisis.

There are arguments against the use of the discount window as a tool of monetary  policy. The misinterpretation  of the announcement effect of a change in the discount  rate can exacerbate the economic  problem being addressed by the Fed. Since the use of the discount  rate is rather  infrequent,  by setting the discount rate at a level, the spread between market interest rates and the discount rate may fluctuate widely as market  interest  rates change. These fluctuations  may lead to unintended fluctuations  in the volume of discount  loans and  consequently  in the  money  supply. The use of the discount  window to bail out financial institutions exerts some financial burden on the public, thereby  creating  negative long-run  consequences  on the economy. The action of bailing out large financial institutions under the guise of “too big to fail” impeded the functioning of a competitive market system.

Interest And Inflation Rates

The other concept of discount rate is as a function of both  interest  rate and inflation  rate. There are four fundamental  factors affecting the cost of money and they are production opportunities, time preferences for  consumption,  risk,  and  inflation.  The  production opportunities define the returns  available in an economy  from  productive  assets. The time  preferences for consumption reveal consumer  preferences between current  consumption and saving toward future  consumption.  Moreover,  the  market   interest rate accounts of risks as well. Risk represents  the likelihood that investors do not realize their expected rate of return  on an investment. In other words, risk consists of a possibility that  an unfavorable state of nature  appears to determine  the variability of future financial flows, thereby making them  unpredictable. The inflation rate is the rate of general increase in the prices of goods and services, making it an index of change in the purchasing power of money. A discount rate accounts for the competing forces of interest and inflation. In general, the market interest rate is associated with the cost of borrowing money and thus represents the earning power of money.

The concept of time value of money in finance and accounting is also based on the use of a discount rate. Time value of money is based on the idea that a dollar today is worth more than a dollar expected next year with all things being equal. Consider a major proposal by a business enterprise  that  is expected to generate $161,000 in one year. Assume that the present value of this future amount is $140,000. The present value is the amount  of cash that makes the owner of the firm be indifferent between receiving $140,000 today or receiving $161,000 next year. This means that the business owner expects to receive a 15 percent  rate of return from the project. Therefore, $140,000 invested at the rate of 15 percent for a year will yield $161,000. In this case, 15 percent is referred to as the discount rate.

Bibliography:   

  1. Eugene F. Brigham and  Joel F. Houston, Fundamentals  of Financial Management  (South-Western, 2009);
  2. “Fed Lowers Discount  Rate; Surprise  Response to Market Turmoil,” Facts on File: Weekly World News Digest with Cumulative  Index (v.67/3480, 2007);
  3. Lutz Hendricks, How Important Is Discount Rate Heterogeneity for Wealth Inequality? (Ifo Institute  for Economic Research, 2005);
  4. F. Madigan and W. R. Nelson, “Proposed Revision to the Federal Reserve’s Lending Programs,” www.federalreserve.gov (cited March 2009);
  5. Mayer, J. S. Duesenberry, and R. Z. Aliber, Money, Banking and  the Economy (Norton, 1996);
  6. Frederic S. Mishkin and Stanley G. Eakins, Financial Markets and Institutions (Pearson Prentice Hall, 2009).

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