The Consequences of Punishing Banks for Using the Discount Window


You may be surprised to learn that the Federal Reserve closely monitors something that has nothing to do with employment, interest rates, or inflation, but rather something behavioral — something that can’t be directly influenced by the Fed chairman or other members of the FOMC. 

What I’m referring to is investor perception.

The reason investor perception is important is that, in order for the Fed to meet its responsibilities to the American people, they need market players to behave in a way that is parallel with how the Fed models rational behavior. This applies to investors, consumers, businesses, and most importantly because they interact with them on a daily basis, banks. If the Fed’s behavioral assumptions are wrong, forecasts of the economy are wrong. 

Luckily, though, the Fed is pretty good at modeling behavior; rarely does the Fed miss to the extremes that academic economists do. But over the past few months, something strange has happened, something that questions long-held assumptions of how banks should operate during economic expansions like today. 

The issue? Banks aren't lending to each other.

I know it seems odd, and it certainly flies in the face of how we assume banks operate when times are good, but what’s stranger is that the financial sector is drowning in cash. 

But “If banks are drowning in cash, why would they need to borrow from anyone?”

The answer to that is pretty simple: no bank is the same; even the most capitalized banks run into cash shortfalls through no fault of their own. Usually, though, banks with excess cash will make intra-day or overnight loans to those in need of cash, but because stock markets have placed such an enormous value on solvency in recent years, banks have become rather hesitant to part with their excess reserves, otherwise they run the risk of investor retaliation through short positions.

As a result, banks in need of cash have resorted to borrowing, at a premium, from the Fed's Discount Window. Though, this can be a problem for publicly traded banks because of the stigma that's attached with it. If a bank taps the Discount Window, it is often perceived as a last ditch effort to raise cash before going under. (This is an absurd interpretation, but unfortunately it’s the world we live in.) Even if the bank has ample reserves and simply wants to increase its liquidity cushion, the mere action of borrowing from the Fed, rather than another bank, is a signal to the market that their business model shaky, and traders should short its stock.  

When such inferences are acted upon, especially en mass, situations arise like those witnessed on September 16th, when the Fed Funds rate shot up 10% in just a few hours because the demand for cash drastically exceeded supply, forcing the Fed to step in and directly inject the market with reserves to keep the Fed Funds rate within its stated policy range.

And this is the bigger issue. When inter-bank lending grinds to a halt, and investors punish those who borrow from the Fed, monetary policy becomes much harder to control because the Fed Funds rate—the rate that shot up 10% in just a few hours—is the benchmark the Fed uses to steer the entire economy. If this rate gets out of the Fed's control, serious problems will arise, as nearly all borrowing in the US is in some way correlated with the Fed Funds rate. 

So what can the Fed do to fix this besides intervening every time the Fed Funds rate goes haywire? 

One solution could be to discontinue the practice of publicly disclosing who borrows from the Discount Window. The disclosures are what traders use to justify their short positions, so if the Fed stops disclosing the debtor banks, traders won’t have the information they need to hammer the stock. 

Transparency defenders certainly won’t like this; they will say such an action disposes of the vital contribution these trades offer investors in alerting them to under-capitalized banks, but that just isn’t the case if well-capitalized banks are forced to borrow from the Fed due to a decline in inter-bank lending. 

Further, the Fed requires debtor banks to post sufficient collateral before borrowing through the Discount Window, so the argument that only insolvent banks are the ones who borrow from the Fed is rather weak.

The question policymakers need to address is: do we want banks to fear borrowing from the Fed—risking investor retribution if they do, putting themselves in dangerous, illiquid situations if they don't—or do we want a healthy, liquid banking system that serves the needs of our communities?

I think we all know the answer to that one.