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A Window into the Financial Crisis

Discount Window

The term "discount window" evokes a time when a banker came to a Federal Reserve teller window to borrow funds, perhaps to ensure that the bank had sufficient reserves to complete a financial transaction or to maintain its level of required reserves. Since the Federal Reserve had long encouraged banks to seek funds from other sources first, the discount window was a quiet post at the Federal Reserve Bank of Philadelphia in most years. That is, until 2008.

Here's a quick way to picture the change. For all of 2007, the Philadelphia Fed's discount window processed almost $1 billion ($992 million) in cumulative daily total loan value. If that 2007 loan volume was a measure of what one teller window could handle, then accommodating the 2008 loan volume of $2.3 trillion would require nearly 2,300 teller windows.

Of course, rather than approaching a teller window, borrowers today simply call a toll-free number to process a loan. So don't look for any massive office renovations in the Credit and Risk Management unit in Philadelphia's Supervision, Regulation and Credit (SRC) Department. What's another way to view the change?

"Almost any way you measure it, it was an extraordinary year," said Vish P. Viswanathan, vice president and discount officer. Viswanathan explained that several factors contributed to the growth in loan activity, including a change in approach to discount window lending six years ago, the financial crisis and the resulting extraordinarily tight credit markets in 2008, and the addition of new types of Fed lending in response to the crisis.

"Before 2003, bankers had to go through a lot of hoops to get a loan from us, because if we made a loan, it was at a subsidized rate — one that was below the federal funds rate," explained Viswanathan. "Banks could not come to us unless they had exhausted all other sources." He noted that there were restrictions on the use of funds borrowed from the Fed. In addition, bankers received more supervisory oversight from bank regulators when they borrowed from the Fed and had to report to their directors about such borrowing, which added to the perceived stigma of going to the Fed's discount window.

In 2003, the Federal Reserve eased the administrative rules for discount window loans. At the same time, the Fed increased the discount rate to be above the federal funds target rate by a full percentage point. This approach intended to use the interest rate differential — a premium or penalty rate to keep the discount rate above the market rate — rather than administrative rules to encourage banks to find other sources of funds before coming to the Fed to borrow. "So we became, de facto, the expensive money, but with fewer restrictions. Even so, continued perceptions of stigma from borrowing at the discount window kept loan volumes low," he said.

In the past 18 months, in response to a weakening economy and a growing financial crisis, the Fed has significantly reduced the level of short-term interest rates by lowering its target federal funds rate to near zero. It also significantly reduced the spread (premium) between the discount rate and the federal funds target to just a quarter of a point, bringing the discount rate down to a half percent. With lower rates at the Fed's discount window and liquidity scarce as many lenders cut back their lending, more financial institutions chose to borrow at the window.

Typically, depository institutions might need a loan to bolster their reserves due to daily volatility in credit demands, unexpected withdrawals of funds, or seasonal factors. The Philadelphia Fed offers primary, secondary, and seasonal credit at its discount window, as well as 28- and 84-day Term Auction Facility (TAF) loans, one of several new lending programs that the Federal Reserve System added to meet the challenges of the financial crisis.

To qualify for primary credit and the TAF, an institution must be in sound financial condition. Institutions that do not qualify for primary credit may receive short-term secondary credit at a higher rate. In 2008, the Philadelphia Fed made very few seasonal loans, which provide smaller institutions with term loans to manage agricultural- or tourism-related seasonal swings in their normal sources of funds.

Credit and Risk Management works closely with the Bank's regulatory units and with other regulators to gather information about all Third District financial institutions, so the staff has a good idea which credit programs each institution would be able to access. The unit also monitors the financial condition of borrowing institutions during the term of their loans, a task made all the more difficult by the volatile nature of financial markets in 2008. To arrange a loan, depository institutions must have a borrowing agreement approved by its board of directors, naming certain individuals authorized to borrow. In addition, the institutions must pledge collateral, since all discount window loans are made only after they are "collateralized to the satisfaction of the lending Reserve Bank."

When an institution needs a loan, a designated employee calls a Reserve Bank's toll-free number and states how much the institution wants to borrow and for how long. Usually the loan is overnight, but primary credit loans can have terms of as long as 90 days under provisions established in 2008 to address the financial crisis.

The discount window staff then checks the level of collateral pledged by the institution using the Collateral Management System (CMS), a web-based application that tracks all collateral pledged throughout the Federal Reserve System, as well as other records, to see whether the bank can borrow the amount and whether the requestor is authorized under the borrowing agreement. If so, the amount is deposited into the bank's reserve account at the Fed for the requested loan term at the current discount rate.

TAF loans are a little more complicated. The program, first introduced in December 2007, requires institutions to bid on specific auctions of either 28-day funds or 84-day funds. The interest rate paid on TAF loans is determined in the auction. It wasn't until May 2008 that a Third District institution had a winning bid for a TAF loan, and most of the TAF loans in the Philadelphia Fed's District were made in the fourth quarter of 2008. When that occurred, though, TAF loans ended up accounting for 90 percent of the Philadelphia Fed's total loan activity in 2008.

"Along with the considerable increase in cumulative daily total loan value in 2008, the actual number of loans increased four-fold from 107 to 437 loans. The real workload for Philadelphia's staff, however, came from the dramatic increase in collateral management activities, as banks added considerably to their collateral pledged at the Fed," said Viswanathan. Credit Officer Gail Todd noted that many institutions that had never borrowed at the window before pledged collateral in 2008 just in case they would later need to borrow in the midst of the financial crisis. "We have had to educate depository institutions on the various lending programs offered by the Federal Reserve," said Todd. "We walked a lot of institutions through the process of setting up borrowing agreements and pledging collateral at the window. Many institutions were looking to enhance their back-up funding sources for their own contingency planning."

When an institution pledges collateral, Todd and her team must determine if the assets are eligible, whether the Philadelphia Fed can establish a clear legal claim to the assets, and then what lendable, or collateral, value to assign to the assets, using the Collateral Management System.

Kimberly Caruso, a senior specialist in the Credit and Risk Management unit, plays a key leadership role in the Federal Reserve collateral management function by chairing the Business Steering Group (BSG) of the CMS application. As the Fed repeatedly announced new collateral requirements and additional lending programs in response to the crisis, Caruso and other members of the BSG were asked to provide feedback to the CMS team about how to use the application to track collateral for the new lending facilities. Caruso is also an active member on the Federal Reserve System's Collateral Valuation Work Group, which helps determine the "haircuts" taken to establish the "lendable" collateral values. In September, Caruso also hosted a meeting of collateral managers and analysts, which brought together credit risk professionals from across the Federal Reserve to discuss the collateral changes.

Todd noted that all of the focus on collateral management in 2008 is a precursor to the upcoming changes in payment system risk (PSR) policies scheduled for implementation in late 2010 or early 2011. The new PSR policy will require more comprehensive and timely intraday monitoring of collateral levels that will be used to offset fees levied on financial institutions for "overdraft" protection during the day.

"In the future we will see a lot more pressure to make timely determinations of collateral values, with more emphasis on turnaround times," explained Todd. "Every minute that it takes you to process a collateral transaction is time that the financial institution is not getting use of the value, so we're looking at all potential efficiencies to improve the collateral management process."