Discount Rate

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.

[Page 517]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 (DID-MCA), discount window loans were extended to all depository institutions including banks that are non-members 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.

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