Federal Reserve Proposes Rule Forcing Banks to Borrow From Central Bank

Idea meant to reduce stigma of accessing the discount window.

The Federal Reserve building in Washington on Nov. 13, 2023. Madalina Vasiliu/The Epoch Times

The Federal Reserve and other financial regulators are drafting a proposal that would mandate banks to borrow from the central bank at least once per year to diminish the stigma of using the discount window.

Alongside the Federal Deposit Insurance Corp. (FDIC) and the Office of the Comptroller of the Currency (OCC), the Fed aims to ensure that financial institutions are better prepared for a hurried exodus of deposits. The latest regulatory efforts come nearly a year after the banking crisis that saw regional banks endure a tidal wave of client deposit outflows, resulting in the failures of Silicon Valley Bank, Signature Bank, and First Republic Bank.

Since the Fed was established in 1913, which came in response to the Banking Panic of 1907, the discount window has been available to troubled entities. For the past century, the central bank has been viewed as the lender of last resort, and monetary authorities have discouraged lending facility usage unless borrowers are on the cusp of collapse.

Banks have usually hesitated to take advantage of the discount window because Wall Street might view it as a sign of financial trouble brewing at these companies.

However, mandating banks to tap the discount window can reduce this stigma typically associated with borrowing from the central bank, according to Michael Hsu, acting comptroller of the currency.

“It’s almost like doing a fire drill. If it’s required, when a real liquidity fire comes, then the banks can do it in real life,” Mr. Hsu told Bloomberg TV. “Operationally, banks would have to go borrow $1, $100 million, whatever it might be, just to ensure that the procedures, the systems, the people, everything is there and in place to access the discount window.”

It’s unclear if regulators would lower the discount rate, which currently stands at 5.5 percent, to enable usage.

This isn’t an idea that has come out of nowhere.

Financial regulators have been engaging with the industry and are reviewing comments and responses to the trio’s proposals to bolster capital.

In December 2023, speaking at a European Central Bank event, Fed Vice Chair for Supervision Michael S. Barr recommended banks utilize “the discount window in good times and bad.”

“The ability to access funding at a predictable rate through the discount window should figure importantly into banks’ liquidity risk management plans under a range of scenarios,” Mr. Barr said in prepared remarks, noting that there should be a broad array of avenues to access liquidity and that the “discount window borrowing should be an important part of this mix.”

In a message directed to banks, analysts, rating agencies, market observers, and the public, he noted that “using the discount window is not an action to be viewed negatively.”

Early Response

The response has been limited, although early comments have signaled a thumbs-up for the proposal.

Earlier this month, the Group of Thirty (G30), an international organization of academics, bankers, and economists, conveyed its support for “strengthened lender-of-last-resort (LoLR) mechanisms.”

“We would require banks to pre-position enough collateral at the discount window to cover, after the normal haircutting for credit risks, all runnable liabilities—that is, all liabilities excluding capital, long-term debt, swap liabilities, and insured deposits,” said former New York Fed President William C. Dudley, who authored the G30’s study titled “Bank Failures and Contagion: Lender of Last Resort, Liquidity, and Risk Management.” “This more robust LoLR system would enable banks to obtain immediate liquidity in times of stress and avoid fire-selling assets.

“By requiring pre-positioning, we will reduce the risk that uninsured depositors and other short-term claimholders run for the exits during periods of panic.”

Stijn Claessens, project director of the G30 Working Group on the 2023 Banking Crisis and the former head of Financial Stability Policy at the Bank for International Settlements, argued that reforming the LoLR mechanisms is the “most important, most feasible, and lowest-cost reform.”

According to Darrell Duffie, project adviser to the G30 Working Group on the 2023 Banking Crisis and a professor of management at Stanford University, that’s the fastest and most effective way to safeguard the financial system without the need for new legislation.

JPMorgan Chase strategists, writing in a Jan. 19 note to clients, ostensibly favor the new rule because it “has the potential to enhance overall financial stability by improving the liquidity position of [a] bank.”

Bank Term Funding Program

In March, roughly half of the loans that originated from the Bank Term Funding Program (BTFP), an emergency lending facility established shortly after the banking meltdown a year ago, will be due. While the Fed had suggested at the beginning that it could be extended, recent comments from central bankers indicate that it would close on March 11, as scheduled.

Many economists and market analysts have observed the BTFP’s significant growth in recent months. Despite repeated assertions from the current administration that the banking system is sound, strong, resilient, and highly liquid, the BTFP has kept climbing.

For the week that ended on Jan. 17, the facility reached a record high of nearly $162 billion. Since November 2023, the program has experienced a meteoric increase, rising roughly 42 percent.

Some observers had purported that this could signal a banking system in trouble. However, others realized that the substantial boost to the BTFP was a case of companies taking advantage of the situation by using an arbitrage opportunity.

Banks borrowed from the BTFP to park the funds in their accounts at the Fed, earning a 5.4 percent on reserve balances. By comparison, the lending program’s interest rate stands at around 5.1 percent.

That’s manufacturing an event similar to the end of the 1920s, according to Heritage Foundation economist E.J. Antoni.

“The Fed has managed to turn its own assets into liabilities; BTFP is charging a lower interest rate than IOR [interest on reserve balances], creating an arbitrage reminiscent of the bankers’ acceptances debacle the Fed created at the end of the 1920s, which helped cause the ‘29 crash,” he wrote on the social media platform X, formerly known as Twitter.

Until March, analysts will be combing through the financial markets to determine if there are signs of stress as the Fed puts an end to the lending facility.