MNI INTERVIEW: Fed Should Mandate Readiness Of Discount Window

The Federal Reserve needs to do more to modernize the discount window and ensure banks' operational readiness in times of crisis, including mandating testing of the facility at regular intervals, an ex-Federal Reserve staffer and former head of the discount window told MNI.

"It would be useful to say you must use the discount window as a form of liquidity in your contingency funding plan, and to require banks to test it at some frequency to ensure that they know how to use it and are aware of all the operating cutoffs and practical considerations on any given day," said Susan McLaughlin.

Her concerns about the discount window come after the unprecedented pace of March runs on Silicon Valley Bank and Signature Bank that took many by surprise. "The shocking thing about SVB was the speed of the run. The current discount window infrastructure was not designed to deal with that kind of speed."

LENDER OF LAST RESORT

"We need to make sure that liquidity from the lender of last resort can be mobilized quickly when needed to avoid runs that can happen in a matter of hours," McLaughlin said. There is less stigma surrounding the discount window compared to during the financial crisis but noted too many are still reluctant to borrow from the Fed, she added.

McLaughlin, a 30-year veteran of the New York Fed, is advocating the Fed make it easier and faster for banks to use primary credit when they need it, including encouraging eligible institutions to ensure they have the legal agreements and collateral in place. That also means adjusting Fed communications to emphasize discount window borrowing is "no questions asked" and -- recalibrating supervisory practices so banks are prepared.

"I see disconnects between what policymakers say, which is to generally try to encourage use, and how supervisors actually treat discount window borrowing," said McLaughlin, now an executive fellow at Yale University. "Primary credit is not counted as a source of funding in liquidity stress tests or resolution plans. Banks are not required to include it in their contingency funding plans, or be operationally ready to use the discount window as a backup source of liquidity."

In recent months the Fed has pushed to get more banks to sign up to and test access to the discount window, including amending supervisory guidance and automating the loan approval process in a new online application that starts in December.

Fed Vice Chair for Supervision Michael Barr has encouraged banks to test the facility, and suggested it may be necessary to reexamine liquidity requirements. Dallas Fed chief Lorie Logan has called for requiring banks to pre-position some collateral. Cleveland Fed President Loretta Mester this week said it is worth considering requiring banks test their ability to use the discount window, which even some members of Congress have proposed.

McLaughlin said such comments from Fed officials emphasizing the need for banks to test operational readiness at the discount window have been helpful. But she is hoping the Fed takes it one step further and requires readiness.

FHLB PRICING

Additionally, a more thorough assessment of discount window pricing relative to Federal Home Loan Banks is needed, McLaughlin said. The primary credit rate is currently set at the top of the federal funds rate target range, down from a 50 basis point spread before the pandemic.

"It's very difficult in practice to reduce the stigma if you have Federal Home Loan Banks that can offer credit at a cheaper price than the discount window. That is the situation today," she said, expressing the need for a longer-term approach to pricing. "We have to also take a look at the role the Federal Home Loan Banks are playing."

"We can do all these other things to improve bank's readiness and incentives to use the discount window, but if borrowing from the FHLBs remains cheaper then banks are going to tend to rely on them more, particularly if they're not thinking about liquidity risk carefully."