What is a Discount Window?

The discount window is a central bank lending facility meant to help commercial banks manage short-term liquidity needs. Banks that are unable to borrow from other banks in the fed funds market may borrow directly from the central bank's discount window paying the federal discount rate.

Current discount rates are listed on the Federal Reserve's website.

Key Takeaways

  • The discount window is a central bank facility that affords commercial banks very short-term loan (often overnight)/
  • The Federal Reserve extends discount window loans to financial institutions who, in turn, support commercial industries.
  • The discount window rate is higher than the fed funds target rate, which encourages banks to borrow and lend to each other and only turn to the central bank when necessary.
  • The discount window is also used for central banks when they act as lender of last resort.

How a Discount Window Works

The Federal Reserve and other central banks maintain discount windows, referring to the loans they make at an administered discount rate to commercial banks and other deposit-taking firms.

Discount window borrowing tends to be short-term—usually overnight—and collateralized. These loans are different from the uncollateralized lending banks with deposits at central banks do among themselves; in the U.S. these loans are made at the federal funds rate, which is lower than the discount rate. Even foreign banks may borrow from the Federal Reserve's discount window.

Banks borrow at the discount window when they are experiencing short-term liquidity shortfalls and need a quick cash infusion. Banks generally prefer to borrow from other banks, since the rate is cheaper and the loans do not require collateral.

The term refers to the now-obsolete practice of sending bank employees to actual, physical windows in Federal Reserve branch lobbies to ask for loans.

For this reason, discount window borrowing jumps during spells of economy-wide distress, when all banks are experiencing some degree of liquidity pressure: after the tech bubble burst in 2001, for example, borrowing at the Fed's discount window hit its highest level in 15 years.

Borrowing from the central bank is a substitute for borrowing from other commercial banks, and so it is seen as a lender of last-resort measure once the interbank overnight lending system has been maxed out. The Federal Reserve sets this interbank rate, called the Fed funds rate, which is usually set lower than the discount rate.

Example of the Discount Window

The 2008 financial crisis saw the Fed's discount window take on a central role in maintaining a semblance of financial stability. Lending periods were extended from overnight to 30 days, then 90. The rate was cut to within 0.25 percentage points of the federal funds rate; the spread had previously been 1 pp, and as of November 2017, it is 0.5 pp.

In October 2008, the month after Lehman Brothers' collapse, banks borrowed $403.5 billion at the discount window; the previous recession had seen borrowing peak at $3.4 billion (September 2001). 

Special Considerations

The Fed's discount window lends at three rates; "discount rate" is shorthand for the first-rate offered to the most financially sound institutions. The three rates are defined as the primary credit rate, secondary credit rate, and seasonal discount rate. All other interest rates are affected by the discount rate including savings and money market interest rates, fixed-rate mortgages, and Libor rates.

According to the Federal Reserve website:
"Bankers' banks, corporate credit unions, and other financial institutions are not required to maintain reserves under Regulation D, and so do not have regular access to the Discount Window. However, the Board of Governors has determined that such institutions may obtain access to the Discount Window if they voluntarily maintain reserves."

Federal Discount Rate vs. Federal Funds Rate 

The federal discount rate is the interest rate the Federal Reserve charges on loans from the Federal Reserve. Not to be confused with the federal funds rate, which is the rate banks charge each other for loans that are used to hit reserve requirements. The discount rate is determined by the Federal Reserve's board of governors, as opposed to the federal funds rate, which is set by the Federal Open Markets Committee (FOMC). The FOMC sets the Fed funds rate through the open sale and purchase of U.S. Treasuries, whereas the discount rate is reached solely thorough review by the board of governors.

Healthy banks are allowed to borrow all they want at very short maturities (usually overnight) from the Fed's discount window, and it is therefore referred to as a standing lending facility. The interest rate on these primary credit loans is the discount rate itself, which is typically set higher than the federal funds rate target, usually by 100 basis points (1 percentage point), because the central bank prefers that banks borrow from each other so that they continually monitor each other for credit risk and liquidity. 

As a result, in most circumstances the amount of discount lending under the primary credit facility is very small, intended only to be a backup source of liquidity for sound banks so that the federal funds rate never rises too far above its target—it theoretically puts a ceiling on the Fed funds rate to equal the discount rate.

Secondary credit is given to banks that are in financial trouble and are experiencing severe liquidity problems. The central bank's interest rate on secondary credit is set at 50 basis points (0.5 percentage points) above the discount rate. The interest rate on these loans is set at a higher penalty rate to reflect the less-sound condition of these borrowers. Under normal circumstances, the discount rate sits in between the Fed Funds rate and the secondary credit rate. Example: Fed funds rate = 1%; discount rate = 2%, secondary rate = 2.5%.