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