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Monday, November 24, 2014

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SRC Insights: First Quarter 2007

Primary Credit and Operating Circular 10

Three years ago-on January 9, 2003-the Federal Reserve implemented two new discount window facilities, the primary and secondary credit programs, replacing the old adjustment and extended credit programs.1 These programs provide discount window loans at rates above the usually-prevailing market rates for overnight interbank loans. The change to an above-market rate and accompanying changes in eligibility requirements make it possible to minimize administration of discount window lending. For instance, under the primary credit program, requests for overnight loans by depository institutions in sound financial condition normally are approved on a "no-questions-asked" basis. Collateral requirements remain in place; every discount window loan must be secured to the satisfaction of the Reserve Bank extending the loan.2

The 2003 changes to the discount window credit programs did not imply any change in the stance of monetary policy as measured by the Federal Open Market Committee's (FOMC) target for the federal funds rate. Rather, the revisions aimed to make the discount window a more effective monetary policy tool by making discount window credit more readily available and by increasing depository institutions' willingness to borrow from the discount window when money markets tighten.

Primary Credit Program
Primary credit serves as the principal safety valve to ensure adequate liquidity in the banking system. Primary credit is currently priced 100 basis points above the FOMC's target for the federal funds rate and is available as a backup source of funds to depository institutions that are considered sound by Federal Reserve Banks. Eligibility is determined largely by the institution's supervisory examination rating and capital status; supplementary information, such as public debt ratings, other market information, and periodic input from examiners, may also be considered. Generally, institutions with a composite CAMELS rating of 1, 2, or 3 that are at least adequately capitalized are eligible for primary credit, unless supplementary information indicates that their condition is not generally sound.3

Primary credit is extended on a very short-term basis, typically overnight, to eligible institutions with a "no-questions-asked" approach. Primary credit may also be extended for up to two weeks to smaller institutions in sound financial condition that cannot obtain temporary funds in the market at reasonable terms. Institutions need not seek alternative sources of funds before requesting occasional short-term advances from the primary credit program. There is no prohibition against using primary credit to fund sales of federal funds. Except in unusual circumstances, depository institutions will not be questioned about the reason for obtaining primary credit.

Secondary Credit Program
Depository institutions that are ineligible for primary credit may be able to obtain discount window credit through the secondary credit program. The secondary credit rate is 50 basis points above the primary credit rate and has a higher level of Reserve Bank administration and oversight than primary credit.

Secondary credit is extended to institutions primarily to assist in their timely return to a reliance on market funding. Secondary credit may also be extended to assist in the orderly resolution of a troubled institution. Section 201.3(d) in Regulation A provides that an institution cannot receive secondary credit as the medium or agent of another depository institution except with the permission of the Federal Reserve Bank extending the credit. In other words, the Federal Reserve expects a borrower of secondary credit to use the funds to help resolve its own financial difficulties.

Primary vs. Secondary Credit at a Glance
Feature Primary Credit Secondary Credit
Rate Currently 100 basis points above the FOMC's target for the federal funds rate. Primary credit rate plus 50 basis points.
Term Short-term, usually overnight, but can also be extended-ordinarily to very small institutions-for up to a few weeks if such credit cannot be otherwise obtained in the market on reasonable terms. Short-term, usually overnight. Can be extended for a longer term if such credit would facilitate a timely return to reliance on market funding or an orderly resolution of a failing institution, subject to statutory requirements (FDICIA restrictions).
Eligibility Depository institutions in generally sound financial condition; generally same as eligibility for daylight credit. Depository institutions that do not qualify for primary credit.
Use Generally no restrictions. May be used to fund sales of federal funds. As a backup source of funding on a very short-term basis or to facilitate an orderly resolution of serious financial difficulties.
Administration Ordinarily no questions asked. Reserve Banks will collect information necessary to confirm that borrowing is consistent with regulatory requirements.

Impact of Primary and Secondary Credit Programs
With discount rates above usually prevailing market levels, there is less need for Reserve Banks to administer discount window loans-especially primary credit loans to financially healthy institutions. The Federal Reserve expects that reduced administration can help eliminate the "stigma"-real or perceived-associated with discount window borrowing. With a "no-questions-asked" approach and no restrictions on the use of funds obtained through the primary credit program, the Federal Reserve expects that financially sound institutions will use the discount window as a backup source of funds more readily than in the past. In particular, institutions should be more willing to use the window when money markets tighten, thereby limiting the volatility of the federal funds rate. In other words, the primary credit rate facilitates the implementation of monetary policy by creating a "cap" and limiting temporary upward "spikes" in the federal funds rate.

Since the implementation of primary credit, there has been an increase in the level of activity at the discount window. The no-questions asked" approach to lending to financially sound institutions may have reduced some of the stigma associated with the previous credit programs. In addition, throughout the Federal Reserve System, a few institutions have accessed primary credit specifically when the federal funds rate has experienced a temporary upward spike.

In July 2003, the Federal Reserve issued a joint press release with the other federal regulatory agencies to provide guidance on the appropriate use of primary credit in a depository institution's liquidity and contingency planning.4 The guidance states that primary credit provides an additional source of backup funds for managing short-term liquidity risks and can expand the source of contingency funding.

Operating Circular No. 10
In order for your institution to use primary credit, the necessary documentation and collateral arrangements must be in place. Required documentation is found in Operating Circular No. 10 (OC-10). OC-10 establishes the conditions under which depository institutions can access primary credit and pledge collateral to the Reserve Bank.

On October 15, 2006, the Federal Reserve Banks revised OC-10, replacing the version effective in January 1998. The revisions made to OC-10 reflect changes in secured lending law incorporated in Article 9 of the Uniform Commercial Code and amendments to Regulation A. The circular also incorporates the increased importance of contingency planning and flexibility in contingencies.

All Third District depository institutions with borrowing documentation on file with the Federal Reserve Bank of Philadelphia received a letter in October 2006, in which they were asked to re-implement the agreements in OC-10. Institutions were requested to complete three documents: 1) Letter of Agreement to OC-10, 2) Authorizing Resolution of Borrowers, and 3) Form of Certificate. Subsequent to the mailing, Reserve Bank discount window staff called all institutions to offer guidance in completing the documents. Discount window staff are currently working with over 190 institutions to assist them in properly completing these agreements.

Contacts and Information
Third District institutions that would like to request a discount window loan should use our toll-free number: 1-800-372-2011. In addition, institutions with any questions about the primary and secondary credit programs should feel free to contact Vice President and Discount Officer Vish Viswanathan at Vish.Viswanathan@phil.frb.org or (215) 574-6403 or Manager Gail Todd at Gail.Todd@phil.frb.org or (215) 574-3886. Depository institutions that do not currently have borrowing agreements on file with the Federal Reserve may want to contact us to discuss their eligibility to use the discount window or collateral requirements and to complete the required agreements.

Please visit the Federal Reserve System's discount window website at www.frbdiscountwindow.org for additional information about the primary and secondary lending programs, as well as the revisions to OC-10.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.