What is the Fed’s discount window, and how does it help during times of crisis?
As appeared in the Cleveland Fed Digest's Ask the Expert
Let me start with what banks do. Banks take their customers’ deposits, and they use that money to make car loans, home loans, and business loans for other customers. When money has been lent out like this, banks can’t use it for paying their own bills—a utility bill, for example. If banks don’t have enough cash on hand to fund their operations, they typically borrow from another bank that does have the cash. It is not that banks don’t have the wealth to pay their bills. It’s that when their money is tied up in other ways and something happens—an investment opportunity arises or many borrowers take out loans, for example—banks will borrow from each other in the short term to ensure they close the day with positive balances.
Such borrowing between banks works well under normal economic circumstances. But what happens in a situation like the one we are in now—when people become concerned about the economic impact of a healthcare crisis, nonessential businesses have been ordered to close, and people are sheltering in place? A lot of businesses are going to be borrowing from banks for reasons and amounts that will be different from how they do business normally. Consumers who stay in are withdrawing cash to minimize their visits to the ATM. Banks know that there are loan payments that are probably going to be missed. They know that they’re going to have to change the terms of loans so that borrowers can repay their loans. The result? All of a sudden, banks aren’t lending to each other because they need their money to give to their customers and to create more of a cushion for possible losses on loans.
The current situation is a classic economic example of why the central bank and the discount window exist. Through the discount window, the Fed lends money to banks. As of March, the Fed is charging pretty close to nothing for banks to borrow, and it’s allowing them to borrow for longer periods of time. Note that only the safest and soundest banks may borrow in this way, and they have to pledge high-quality collateral such as loans and securities in order to borrow from the Fed. That way, in the event the borrowing bank doesn’t repay its loan, the Fed has collateral it can sell to recoup the money it lent.
When we’re in a situation where banks won’t or can’t lend to each other, the Fed provides the cash to ensure banks can continue to operate and—despite the economic downturn—continue to make loans to households and businesses that support our nation’s economy. Loans are an important contributor to economic growth. A company that wants to build a new factory often needs a loan to start the process. The loan allows the company to build the factory, hire workers, and start producing goods. Lending is critical, too, for people who want to buy cars, homes, and more, and for municipalities that need to continue to operate or want to expand the services they offer.
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