What Is Rediscount?
A rediscount occurs when a short-term negotiable debt instrument is discounted for a second time. The reason an issuer would do this is to cause a spark demand for loans when investor interest dires up. When liquidity in the market is low, banks can thus try to raise capital by rediscounting.
A rediscount is also a method for commercial banks to obtain financing from a central bank.
- To rediscount refers to lowering the marketable value of a debt instrument for a second time, increasing the difference between the discount price and its par value.
- Rediscounting is used to spark new demand among bond investors in order than firms can raise debt capital in otherwise pessimistic markets.
- Rediscount can also refer to financing provided by central banks to banks, where the central bank will rediscount a discounted promissory note from a borrower to a bank to generate liquidity for the bank.
To entice investors, debt issuers may offer their bonds at a discount to par, meaning that investors can purchase a bond for less than its par value and receive the full par value of the bond when it matures. If the first debt offer does not generate much interest, the issuer may apply an additional discount to the bond, increasing the difference between the discount price and the par value. When this occurs, the issuer is said to rediscount the bonds.
The term “rediscount” also refers to the process by which a central bank or the Federal Reserve bank discounts a note that has already been discounted by a bank or discount house. A central bank's discount facility is often called a discount window. The term comes from the days when a clerk would go to a window at the central bank to rediscount a company's securities.
The Federal Reserve and other central banks are empowered to accept loans and other bank obligations as collateral for advances at the discount window. The discount window is used by the Fed to rediscount private securities as a means to directly provide funding to banks at a particular interest rate and, thus, influence a bank's marginal cost of funds.
Example of Rediscounting
Imagine that a customer that borrows $10,000 from a bank will sign a promissory note stating that it will repay the bank $12,500 after a year. This note is discounted by the bank which subsequently lends out less than the $12,500 face value of the note. The difference of value is the money earned by the bank for the loan.
If a bank wanted to obtain financing from the Federal Reserve, it could rediscount this eligible note at the Fed’s discount window for, say $11,500. In so doing, the Federal Reserve would take ownership of the loan note and provide the member bank with funds against the amount the note promises to pay at maturity.
A central bank would rediscount a note for a commercial bank to assist them with current liquidity constraints, which can be attributed to a variety of factors, including seasonality. A central bank would also rediscount a note for banks that are low on customer deposits, which also creates liquidity issues.