The Fed’s Discount Window: Who, What, When, Where and Why?

The discount window gets its name from an actual former teller window at the Federal Reserve (image circa 1960).

Image courtesy New York Fed

The Federal Reserve has several important purposes and functions, including conducting monetary policy to promote price stability and maximum sustainable employment. It also promotes consumer protection, community development and financial system stability.

Lending to depository institutions is one way the Fed promotes financial system stability. That’s where the discount window comes in. This isn’t a physical window, but it did get its name from actual teller windows at the Federal Reserve where transactions used to take place.

Here’s the who, what, when, where and why of the Fed’s discount window and the discount rate.

Who does the Federal Reserve lend money to?

The discount window is a way the Federal Reserve can lend money to financial institutions, including commercial banks, thrifts and credit unions.

What are discount window loans?

Discount window loans are short term and are often used to address temporary funding shortfalls. There are three main discount window lending programs, plus emergency credit. Collateral plays a role in the lending.

Discount window lending programs

The main discount window lending programs are primary, secondary and seasonal credit:

• Primary credit is offered to healthy, well-capitalized institutions. This is the most common discount window loan type.
• Secondary credit is offered to institutions not eligible for primary credit. Loans are typically only extended on an overnight basis at a rate that is higher than the primary credit rate.
• Seasonal credit is extended to institutions, typically those located in agricultural or tourist areas, that experience significant seasonal fluctuations in deposits and loans.

The Federal Reserve may also offer emergency credit to provide support during financial crises.

Collateral

Getting a loan requires collateral, just like if you took out a mortgage, auto loan or secured personal loan.

Banks needing to borrow from the Fed’s discount window must pledge collateral, such as in the form of securities or loans. The collateral value that these pledged assets receive determines how much the bank can borrow. Collateral values are set by Reserve banks, which base them on fair market value estimates and apply a “collateral margin” to account for historic price volatility and other risk factors.

According to the Federal Reserve Board of Governors, the Fed has never lost a cent on its discount window loans to banks.

When do banks use the Fed’s discount window?

Depository institutions typically borrow from the discount window to address temporary funding shortfalls that may arise from timing mismatches in their cash flows or unexpected liquidity strains. For example, an unexpected decline in a bank’s deposits may impact its available liquidity—that is, the cash and assets easily converted to cash that banks keep on hand to meet financial obligations. So, in this case, the bank may borrow from the discount window to bolster its liquidity position.

The discount window also plays a vital role during an emergency or times of great stress, such as the aftermath of 9/11 or the 2007-09 financial crisis.

“Historically, the main operation of a central bank is to provide a lending facility—acting as the lender of last resort to the banking financial system—in the event that there is a liquidity shortage, a scramble, a financial panic. The central bank is there to provide that supply of liquidity,” explains David Wheelock, a senior vice president and research economist at the St. Louis Fed. Wheelock’s research focuses include financial and monetary history.

The discount window and the COVID-19 pandemic

In mid-March 2020, as the COVID-19 pandemic placed stress on the financial system, a trio of federal bank regulators (the Federal Reserve Board of Governors, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp.) released a statement encouraging depository institutions to use the discount window to meet demands for credit from households and businesses. A day earlier, the Board of Governors had announced it was lowering the primary credit rate and making other changes to the discount window to encourage more use.

On March 19, the Board released a statement saying it was “encouraged by the notable increase in discount window borrowing this week with banks demonstrating a willingness to use the discount window as a source of funding to support the flow of credit to households and businesses.”

The statement also said, “By providing ready access to funding, the discount window helps depository institutions manage their liquidity risks efficiently and avoid actions that have negative consequences for their customers, such as withdrawing credit during times of market stress.”

The discount window and the 2023 banking crisis

In March 2023, Silicon Valley Bank, which was then the 16th largest bank in the U.S., failed after a run on its deposits. This high-profile failure triggered market panic and a wave of deposit withdrawals, resulting in the failure of Signature Bank just days later and significant liquidity stress across several depository institutions.

The discount window played a crucial role in containing the impact of this crisis and stabilizing the financial system. Just days after the failure of Silicon Valley Bank, all 12 Federal Reserve banks launched the Bank Term Funding Program (BTFP), an emergency lending program meant to “reduce stress across the financial system, support financial stability and minimize any impact on businesses, households, taxpayers, and the broader economy.”

The BTFP offered fixed-rate loans with maturities of up to one year and allowed depository institutions to borrow up to the par value, or face value, of eligible securities, increasing their borrowing capacity. As a stable funding source, BTFP loans allowed institutions to manage liquidity stresses without resorting to selling off assets.

Where are loans administered?

In addition to the Board of Governors, located in Washington, D.C., the Federal Reserve System includes 12 regional Reserve banks geographically located around the country.

These Reserve banks are in charge of extending discount window loans to banks in their respective districts.

The Federal Reserve Bank of St. Louis is among these 12 regional banks. It provides credit to depository institutions across the Eighth Federal Reserve District, which includes all of Arkansas and parts of Illinois, Indiana, Kentucky, Mississippi, Missouri and Tennessee.

Why does the Fed have a discount window?

The Fed lends money to banks so that a shortage of funds at one institution does not disrupt the flow of money and credit in the entire banking system. Again, it’s about providing liquidity. Banks need reserves so that, among other reasons, they are not short on cash for customers who wish to make withdrawals.

Also, the discount window has historically played a role in how the Fed influences interest rates. Here’s how.

A discount rate refers to the interest rate charged on loans to banks via the discount window. Rates are established by each Reserve bank’s board of directors, subject to the review and determination of the Board of Governors, and the rates for the three lending programs are the same across all Reserve banks.

Meanwhile, the federal funds rate—the rate you probably think of when you hear news about “the Fed” and “interest rates”—is a market rate that banks charge each other for overnight loans. The Fed’s monetary policymaking body, the Federal Open Market Committee, does not administer that rate. Rather, it sets a target range for the federal funds rate based on the FOMC’s assessment of economic conditions.

The discount rate has traditionally served as a sort of upper bound, or ceiling, on the federal funds rate. The fed funds rate cannot, in principle, go above the discount rate for primary credit … because banks would usually not choose to borrow from another bank at an interest rate higher than the rate it could get from the Fed. So, banks wanting to lend to other banks in the fed funds market had a competitive incentive to charge a lower rate than the Fed.

Amid and after the Great Recession, the details of how the Fed conducts monetary policy changed. Since late 2008, the Fed has been authorized to pay interest on the reserves that banks hold with the Fed. This rate is set by the Board of Governors.

Just as the discount rate provides a ceiling, the interest paid on excess reserves provides a sort of floor for the fed funds rate, Wheelock says: “In principle, no bank would ever lend in the federal funds market at a rate lower than what it could get by ‘parking’ reserves at the Fed. The fed funds rate should be—again, in principle—at or above the interest rate on reserves.”

In conclusion …

• In “normal times,” the discount window helps to promote stable conditions in the interbank market for reserves.
• During times of great stress, it’s a crucial tool for providing liquidity to the financial system—thus helping to keep the economy running.

Communications and Engagement staff contributed to this blog post.