2 Discount Window loans are generally described as overnight loans, and had traditionally been. Due to actions taken by the Federal Reserve in response to market events, however, depository institutions can take Discount Window loans out for any term between overnight and up to 90 days. In August 2007 the Federal Reserve Board announced a change to allow the provision of term financing for as long as 30 days, renewable by the borrower. Then in March 2008 the Board approved an increase in the maximum maturity of primary credit loans to 90 days.

So, in essence a 28-day term Discount Window loan could be secured by a depository institution – a loan that would be similar to using the TAF’s structure, but at lower rate.

Also, it is worth highlighting that another structural difference between the TAF and the Discount Window is that a Discount Window loan can be prepaid at the option of the depository institution while the TAF cannot. This suggests that an institution with all other factors being equal, and absent consideration of any "stigma" or signaling issues, might use the Discount Window over the TAF.

3 By some accounts the reporting of Discount Window borrowing by Federal Reserve District is particularly concerning to a firm in a District which has few large participants – because any large borrowings from within such a District are likely to be done by only a limited pool of institutions, making market speculation more finely focused.

4 Recently, the financial press has reported on market speculation that Libor fixings are being under-reported.

From the footnotes

Similarly, firms’ concerns about signaling have hampered the ability of the Federal Reserve to encourage borrowing from the Discount Window during times of stress. A particularly interesting example of this occurred last week with the latest auction conducted under the auspices of the Federal Reserve’s new Term Auction Facility (TAF).

The results of the latest TAF auction are shown on Figure 1. Allow me to provide a bit of background.

The TAF is an alternative to a Discount Window loan. Both result in a loan from the Federal Reserve to a financial institution, collateralized by assets that the borrowing institution has pledged to the Federal Reserve. However, with the addition of the TAF, financial institutions have two ways to borrow from the Discount Window. They can borrow using a traditional Discount Window loan, which is a loan at the primary credit rate – traditionally overnight but now up to 90 days term.2 Currently the primary credit rate is 25 basis points over the Federal Funds rate, or a rate of 2.5 percent. Alternatively, they can borrow for 28 days by participating in the Term Auction Facility, where the bidder is free to bid for funds at any rate above the minimum required for the auction (2.11 percent in the latest auction), and all those bids that are above the stop-out rate get the stop-out rate for the loan.

As can be seen in the graph, last week the stop-out rate was 2.82 percent, significantly higher than the primary credit rate of 2.5 percent. Such a bid could be explained if market participants believed it was likely that market rates would rise over the 28 day term, but evidence from trading in Federal Funds futures and in overnight index swaps indicate the opposite – that market participants believe it is far more likely that the Federal Funds rate will fall from its current target. Similarly, the TAF stop-out rate exceeds the one-month London Interbank Offered Rate (Libor), the rate at which banks can borrow one month unsecured money in London.
So how can this seeming anomaly be explained?

First, the Federal Reserve does not trade for profits in the markets, so the firms can bid in the auctions without fearing that their bids imply any immediate signaling of potential balance-sheet constraints or liquidity problems to the counterparty, the Federal Reserve. As a result, firms may be willing to pay a premium for transacting with the Federal Reserve in order to avoid any immediate public signaling, and to avoid taking actions that could potentially be construed as signaling the existence of problems.

Second, firms may want to be sure that they have some term funding, and by placing bids well above the primary credit rate they are in effect offering the equivalent of a non-competitive bid in a Treasury auction. They are willing to purchase the use of the term funds at whatever the current market clearing price is in the auction, even if there are less-costly options at the Discount Window or with private parties.

Third, the winners of TAF auctions are not disclosed by the Federal Reserve. Of course, neither are institutions that take out Discount Window loans disclosed by name. However, market participants may believe that the auction process, where a variety of 5 banks are jointly acquiring funds, may be interpreted differently than an individual institution borrowing from the Discount Window.

The volume of term lending transactions has declined significantly, with few buyers or sellers of term funds. I can suggest several reasons.

First, many potential suppliers of funds have become increasingly concerned about their capital position, causing them to look for opportunities to shrink (or slow the growth of) assets on their balance sheets, in order to maintain a desirable capital-to-assets ratio. Since unsecured inter-bank lending provides relatively low returns and has little benefit in terms of relationships, banks may prefer to use their balance sheet to fund higher-returning assets that advance long-term customer relationships.

Second, as the uncertainty over asset valuations has increased, banks have become reluctant to take on significant counterparty risk to financial institutions – particularly with those that have significant exposure to complex financial instruments.

Third, many potential borrowers are reluctant to buy term funds at much higher rates than can be obtained overnight, for fear that they may signal to competitors that they have liquidity concerns. However, when the counterparty is a central bank, financial institutions have been quite willing to buy term funding, sometimes at rates higher than they would expect if they were to borrow funds overnight.

I believe this period of illiquid markets should also cause central banks to re-evaluate their roles. For a central bank to play an effective role during financial turmoil, it needs to understand the sources of liquidity problems, the interrelationships between market participants, likely losses, and market participants’ potential reactions to these losses

In my view, this can only be done if the central bank has some form of hands-on supervisory experience with institutions – particularly the "systemically important" institutions – regardless of who is the primary regulator. The Federal Reserve has been far more effective during this crisis because it has hands-on experience with bank holding companies that are among the most significant players in many financial markets.

In short, there are significant synergies between bank supervision and monetary policy during periods of financial turmoil – synergies that can be used to achieve better outcomes for the public as policy makers try to determine the impact of liquidity problems and how changes in credit will impact the broader economy

Having some form of similarly hands-on supervisory experience with any systemically important financial institution that may need to access the Discount Window is, in the long term, critically important. We need to understand the solvency and liquidity positions of firms that may access the Discount Window – with access, at the very least, to the information any counterparty would require in a lending relationship. For those financial institutions that do have access to the Discount Window, there is indeed a need for the Fed to have broader access to information than marketplace counterparty creditors, if we are to effectively manage our responsibilities as lender of last resort and custodian of financial stability. So, regardless of who is the primary regulator, it is important for the Fed to understand the consolidated capital and liquidity positions of such firms.

There is no way to put the genie back in the bottle ... Even if we were to announce that we're never going to lend to investment banks again, would that be credible given what we've done.

As reported by Bloomberg News

No matter what the short-term benefits of that action were, or the other credit market interventions that we have undertaken, there is undoubtedly a risk of adverse incentive effects down the road and perhaps even in the near term as well.

From comments to press, as reported by Reuters

[N]ow we must do what we can to remedy the situation. One thing, however, is clear. The answer, to be curt, is not to compound the bad by repeating the oft-prescribed remedy of inflating our way out of our predicament with a wing-and-a-prayer promise that it can always be reined in later. It is for this reason that I have maintained a strong reluctance to further general monetary accommodation. At the same time, I have been an advocate of using our various discount window facilities, within reason, to bridge the financial system’s structural problems as the credit markets correct themselves and run the long course of contrition.

[The problems with LIBOR] do not hurt the efficacy of the liquidity programs put in place.

From Q&A as reported by Reuters

Although our actions appear to have helped stabilize the situation, financial markets remain under considerable stress. For example, many lenders have been reluctant to provide credit to counterparties, especially leveraged investors, and have increased the amount of collateral they require to back short-term security financing agreements. Credit availability has also been restricted because some large financial institutions, including some large commercial and investment banks, have reported substantial losses and asset write-downs, which reduced their available capital. The capacity and willingness of some large banks and other financial institutions to extend new credit has also been limited by the reduced availability of external funding from the capital markets for originated assets. The resulting unplanned increases in their balance sheets have strained their capital, thus reducing lending capacity. The good news is that several of these firms have been able to raise new capital, and others are in the process of doing so. However, market stresses are likely to continue to weigh on lending activity in the near future.

Collectively, these innovations provide for much longer terms of lending, broader types of collateral, a wider class of counterparties, and a tighter spread between the primary credit rate and the target federal funds rate. All of these innovations are designed to bolster market liquidity and promote orderly market functioning. Liquid, well-functioning markets are essential for promoting financial stability and economic growth.

The priority focus should be figuring out new ways to enhance liquidity, reduce the fear that people have as counter-party risk
...
We recently opened up our window to lend to what are called primary dealers. I fully expect that in return for that we will get regulatory authority to actually oversee those dealers, to make sure the people we're lending money to are adhering to the principles of good financial behavior.

As reported by Reuters

Together these policy actions expand our role by providing liquidity in exchange for sound but less liquid securities. These policy innovations share important features of increasing both the term and the quantity of our lending and making additional quantities of highly liquid Treasury securities available to financial intermediaries. This is intended to reduce uncertainty among financial institutions and allow them to meet the liquidity needs of their clients.

While these policy actions represent major innovations in practice, they are in the spirit of the oldest traditions of central banking. As described by Walter Bagehot in his 1873 treatise Lombard Street, the job of the central bank is to "lend freely, against good collateral" whenever there is a shortage of liquidity in markets.

I'm very supportive of the Fed's action. I think they've taken a number of innovative steps to provide term liquidity. That's really what the market needs.

From press Q&A, as reported by Market News International

The Federal Reserve has taken a very pro-active stance in response to what we view as economic developments. We have other tools to work in terms of market liquidity, the term auction facility, for example ...

I would discourage you from thinking that simply because, or because of, significant action in the credit market like we had yesterday that suddenly we are going to have a meeting of the Open Market Committee ... and that suddenly we are going to move Fed Funds rates. It doesn't work that way.

As reported by Market News International

I would now like to say a few words about the adequacy of our toolkit during periods of financial disruptions. We have several ways to add liquidity to the economy in addition to the normal open market operations: the discount window—extended to term borrowing and the new Term Auction Facility—and foreign exchange swaps to help enhance liquidity abroad. In these operations we accept as collateral assets that others see as less readily marketable. I do not think this adds undue risk since we only lend to qualified solvent institutions and the collateralization rates include appropriate haircuts on riskier assets. In addition, we sterilize the effects of the borrowings on aggregate reserves, so that the liquidity injections are done while maintaining the fed funds rate target. This keeps the funds rate at a level we see as consistent with achieving our announced policy goals.