Tuesday, September 15, 2009

The Federal Reserve‘s Discount Rate

The discount rate is the interest rate charged by the Fed on loans of reserve secured by U.S. government securities or other acceptable collateral. In reality, there are four different discount rates. The cheapest rate applies to loans (advances) for short-term liquidity adjustment or seasonal needs secured by U.S. government securities or high-grade commercial ("eligible") paper. In the summer of 1981 this rate was 14 percent. A slightly higher interest rate is levied against discount window loans secured by collateral of lesser quality. In times of national emergency, the Fed may also extent credit to individuals, partnerships, and even nonfinancial corporations, but the interest rate is much higher on such loan.
An interesting development occurred in 1981 when the Fed imposed a penalty rate on borrowing by the nation‘s largest depository institutions. Effective May5,1981, a 4 percent surcharge was applied to short-term borrowings by financial institutions holding total deposits of 500$ million or more when these institutions attempted to borrow in successive weeks or in more than four weeks in a calendar quarter. Because the discount rate was we below interest rates on federal funds, CDs, and other popular sources of reserves, many large banks were using the window to support their lending operations, contributing (in the Federal Reserve‘s opinion) to inflationary pressures. The 4 percent surcharge brought the cost of Fed loans closer to open-market rates and encouraged larger banks to look elsewhere for funds.
The individual Federal Reserve banks often recommend that the discount rate be changed; however, a change in that rate must be approved by the Federal Reserve Board in Washington, D.C. In recent years the Fed has lived a higher interest rate for emergency borrowings when a bank is in serious financial trouble. Large, continuous borrowings over a prolonged period of time may be approved at a rate of 1 to 2 percent above the regular Federal Reserve discount rate.

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