how the fed s discount rate works
commercial banks in the u s have two primary ways to borrow money for their short term operating needs they can borrow and loan money to other banks without the need for any collateral using the market driven interbank rate or they can borrow money for their short term operating requirements from the federal reserve bank federal reserve loans are processed through the 12 regional branches of the fed the loans are used by financial institutes to cover any cash shortfalls head off any liquidity problems or in the worst case scenario prevent the bank s failure this fed offered lending facility is known as the discount window the loans are incredibly short term 24 hours or less the rate of interest charged is the standard discount rate the board of governors of the federal reserve set this discount rate 1the fed s discount window program runs three tiers of loans each using a separate but related rate it also allows for emergency credit approvals for banks in distress the fed determines the discount rates for the first two tiers independently the rate for the third tier is based on the prevailing rates in the market all three types of the federal reserve s discount window loans are collateralized the bank needs to maintain a certain level of security or collateral against the loan emergency credit may require collateral but it s based on circumstances and the fed s vote borrowing institutions use this facility sparingly mostly when they cannot find willing lenders in the marketplace the fed offered discount rates are available at relatively high interest rates compared to the interbank borrowing rates to discourage using the discount window too often the discount window is primarily intended as an emergency option for distressed banks borrowing from it can even signal weakness to other market participants and investors example of fed discount ratethe use of the fed s discount window soared in late 2007 and 2008 as financial conditions deteriorated sharply and the central bank took steps to inject liquidity into the financial system in august 2007 the board of governors cut the primary discount rate from 6 25 to 5 75 reducing the premium over the fed funds rate from 1 to 0 5 in october 2008 the month after lehman brothers collapse discount window borrowing peaked at 403 5 billion against the monthly average of 0 7 billion from 1959 to 2006 owing to the financial crisis the board extended the lending period from overnight to 30 days then to 90 days in march 2008 2 once the economy recovered those temporary measures were revoked and the discount rate was reverted to overnight lending only the fed maintains its own discount rate under the discount window program in the u s most central banks across the globe use similar measures although they vary by area for instance the european central bank ecb offers standing facilities that serve the same purpose financial organizations can obtain overnight liquidity from the central bank against the presentation of sufficient eligible assets as collateral 3most commonly the fed s discount window loans are overnight only but the loan period can be extended in periods of extreme economic distress such as the 2008 2009 credit crisis 