What is Federal Reserve Credit?
Federal Reserve credit refers to the act of the Federal Reserve lending funds on a very short-term basis to member banks in order to meet their liquidity and reserve needs. By lending money to member banks, the Federal Reserve helps to maintain the steady flow of funds between consumers and banking institutions.
Federal Reserve credit is most often extended by way of the "discount window," which is the Federal Reserve's primary program of lending funds to member banks. The discount rate at which banks borrow depends on the creditworthiness of each bank, as well as the overall demand for funds at any given time. The Fed also lends Federal Reserve credit to banks and businesses and financial institutions through various special lending facilities established from time to time.
- Federal Reserve credit is funding lent by the Federal Reserve to eligible banks and other institutions in its function as lender of last resort to support the financial system.
- Eligible institutions can borrow Federal Reserve credit bridge loans against collateral to meet short-term liquidity needs and reserve requirements that they might not otherwise be able to obtain on the open market.
- The Fed lends Federal Reserve credit through its regular discount lending programs as well as through temporary special lending facilities established from time to time during periods of financial stress.
Understanding Federal Reserve Credit
As complicated as the money system can appear to be, the concept of Federal Reserve credit is surprisingly simple. In essence, the Federal Reserve extends credit as a bridge loan to get banks through short periods of time when their liquidity needs to meet current obligations, while also maintaining Federal Reserve requirements that could not otherwise be met. The Federal Reserve's routine procedure of lending to member banks is highly regulated and backed by the collateral of each bank borrowing the money.
This type of lending constitutes one of the original, primary functions of the Federal Reserve to act as a lender of last resort for troubled financial institutions. Early in the Fed’s history, Federal Reserve discount lending constituted it’s primary monetary policy tool, and was offered at punitively high rates against solid collateral. Over time these standards have eased more and more as the Fed’s monetary policies have become more expansionary and accommodative toward the financial sector, lending at below market rates against increasingly risky forms of collateral. Depending on the conditions this can be thought of as a kind of open-ended bailout program for banks and other financial institutions.
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 of reserves that banks do among themselves; in the U.S. these loans are made at the federal funds rate, which is lower than the discount rate.
The Fed's discount window actually lends through three programs: primary credit, secondary credit, and seasonal credit.
The Fed offers primary credit to well capitalized banks as a back-up to other market-based sources of funding. Banks are not required to seek other sources of credit first, but are expected not to use Fed primary credit as a regular source of funding. The "discount rate" is shorthand for the primary rate offered to the most financially sound institutions.
Secondary credit is offered, at a higher interest rate, to banks that are not eligible for primary credit. These are usually banks that are under some financial distress and are unable to obtain credit on the open market. Secondary credit loans involve a higher degree of administrative oversight from the Fed for the borrower and can signal that an institution is at high risk of default or bankruptcy.
Seasonal credit is offered mostly for smaller institutions that lack the same access to global financial networks as larger banks and whose borrowing demands tend to fluctuate seasonally due to the regions or industries to which they lend, such as construction, student loans, or agricultural financing. The interest rate on Fed seasonal credit is a floating average of various market rates.
Special Lending Facilities
The Fed also lends Federal Reserve credit to banks, other financial institutions, and other organizations through various special lending facilities that it establishes on temporary basis to address financial stresses due to immediate economic conditions such as the financial crisis and Great Recession of 2008 or the economic damages imposed by government shutdowns of the wide swaths of the economy during the Covid-19 outbreak.
Under these programs the Fed accepts a wide range of various types of collateral, and they are often used to target support for the prices of specific asset classes or the liquidity needs of specific industries or types of institutions. Interest rates that the Federal Reserve credit grants through these special lending facilities can also vary, and may be based on discount rates for primary or secondary credit. Rates and allocation of funds can be determined through a secret auction mechanism that conceals the liquidity risk of the borrowers to shield them from market discipline.