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The Discount Window and Other Credit Facilities

2 March, 2015 - 12:11

A major responsibility of the Fed is to act as a lender of last resort to banks. When banks fall short on reserves, they can borrow reserves from the Fed through its discount window. The discount rate is the interest rate charged by the Fed when it lends reserves to banks. The Board of Governors sets the discount rate.

Lowering the discount rate makes funds cheaper to banks. A lower discount rate could place downward pressure on interest rates in the economy. However, when financial markets are operating normally, banks rarely borrow from the Fed, reserving use of the discount window for emergencies. A typical bank borrows from the Fed only about once or twice per year.

Instead of borrowing from the Fed when they need reserves, banks typically rely on the federal funds market to obtain reserves. The federal funds market is a market in which banks lend reserves to one another. The federal funds rate is the interest rate charged for such loans; it is determined by banks’ demand for and supply of these reserves. The ability to set the discount rate is no longer an important tool of Federal Reserve policy.

To deal with the recent financial and economic conditions, the Fed greatly expanded its lending beyond its traditional discount window lending. As falling house prices led to foreclosures, private investment banks and other financial institutions came under increasing pressure. The Fed made credit available to a wide range of institutions in an effort to stem the crisis. In 2008, the Fed bailed out two major housing finance firms that had been established by the government to prop up the housing industry—Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Mortgage Corporation). Together, the two institutions backed the mortgages of half of the nation’s mortgage loans.[2] It also agreed to provide $85 billion to AIG, the huge insurance firm. AIG had a subsidiary that was heavily exposed to mortgage loan losses, and that crippled the firm. The Fed determined that AIG was simply too big to be allowed to fail. Many banks had ties to the giant institution, and its failure would have been a blow to those banks. As the United States faced the worst financial crisis since the Great Depression, the Fed took center stage. Whatever its role in the financial crisis of 2007–2008, the Fed remains an important backstop for banks and other financial institutions needing liquidity. And for that, it uses the traditional discount window, supplemented with a wide range of other credit facilities. The Case in Point in this section discusses these new credit facilities.