The Discount Window Needs Repair

One of five task forces established by Federal Reserve Chairman Kevin Warsh last week will study ways to reach his goal to shrink the Fed’s balance sheet. As the task force’s work proceeds, a principal goal must be to assure banking system stability by addressing the stigma attached to the Fed’s discount window. Absent changes, one of the Fed’s most important tools for protecting our economy will remain hampered.

A fully functioning discount window would provide a safety valve as banks adjust to a shrinking Fed balance sheet. The Fed was created in 1913 to “discount” bank loans, turning them into a source of liquidity for banks. Those discount window loans helped banks meet depositor runs and helped the banking system flexibly meet swings in the demand for currency and credit. Today, the discount window is one of the Fed’s most powerful—and most underused—tools.

The problem is stigma. “Lender of last resort” has come to mean “last resort before failure.” During the financial crisis, borrowing from the discount window was recast as a bailout. Banks took the hint. They stockpile unproductive reserves to ensure they will never have to use it.

That reluctance has consequences. As we saw in March 2023, the speed and scale of bank runs have increased, but the system’s primary liquidity backstop sat idle as banks struggled to meet depositor withdrawals.  Borrowing would not have saved the banks from failure, but could have facilitated a more orderly resolution and reduced the contagion to other institutions.

To reduce stigma, the Fed needs to make discount window borrowing commonplace. If use of the window becomes a normal part of bank funding, it will no longer signal distress. Mr. Warsh has experience with this strategy during his previous service as a Fed governor. To reduce stigma amid panic in 2008, the Fed provided term discount window loans with interest rates determined in auctions. The Fed should make that approach permanent, with weekly auctions of 30- and 90-day funds.    

Congress has noticed. The recently introduced Discount Window Preparedness Act from Sens. Mark Warner (D-Va.) and John Kennedy (R-La.) would push regulators to recognize demonstrated operational readiness and the capacity to borrow against pre-positioned collateral as important elements of prudent liquidity management. The legislation mandates modernization of the systems used to pledge collateral and borrow so banks can access liquidity as quickly as depositors can initiate withdrawals. And it requires cooperation between the Federal Reserve and the Federal Home Loan Bank System. Finally, it calls for a report on stigma. It deserves strong bipartisan support.

The Fed is already making progress—it has automated loan requests and is working with the FHLBs on making collateral transfers between the Federal Home Loan Banks and Reserve Banks, and between securities platforms, faster and more efficient.

The time to fix the window is now. Mr. Warsh has said he plans to shrink the balance sheet and reduce bank reserves to reduce the Fed’s role in in financial markets. With total reserves shrinking, supervisors cannot expect individual banks to maintain their current high levels of reserve balances as liquidity. Instead, banks should be able to preposition their loan portfolios as collateral for discount window borrowing to meet unexpected needs for cash.

Congress created the discount window to stop bank runs. Repairing it will make the financial system safer, help deflate the Fed’s balance sheet, and allow banks to lend to Main Street.

Ms. Duke is a former community banker who served on the Federal Reserve Board from 2008 to 2013. Mr. Nelson is the chief economist at the Bank Policy Institute and worked at the Federal Reserve Board from 1993 to 2016 where he was responsible for discount window policy.  They worked together on emergency lending facilities during the financial crisis.