Fed altering key policy for bank lending

Martin Crutsinger

Friday, May 17, 2002 | 10:15 a.m.

WASHINGTON -- The Federal Reserve today unveiled a significant shift in its operations as the nation's lender of last resort. It proposed making it more expensive for banks to borrow directly from the Fed.

Currently, banks that go to the Fed's discount window are able to get loans that are about a half percentage point below the Fed's target for the federal funds rate, the interest that commercial banks charge each other for loans.

Under the proposal, the Fed would take away that break and instead charge banks using the discount window 1 full percentage point higher rate than the funds rate. If the change is adopted after a public comment period, it would be the most significant change in the Fed's discount window operations in nearly two decades.

Currently, the funds rate target is 1.75 percent, the lowest level in 40 years, and the discount rate is 1.25 percent.

The Fed said it was proposing the change to cut down on administrative costs of screening banks that seek loans directly from the Fed. Because the discount rate is lower than what banks can receive if they borrow from each other on the open market, the Fed monitors to make sure banks are not abusing their access to the discount window as a way to get cheaper money.

By proposing this change to a higher rate for discount window borrowing, the Fed would remove the financial incentive for banks to try to obtain loans from the central bank.

Throughout the Fed's history, the discount window has served as the bank's primary way of serving as a lender of last resort, helping financial institutions obtain the reserves they needed to keep operating during periods when they were short on resources.

Usually, the discount window helps banks keep operating until they get fresh reserves through normal operations. Sometimes, however, the discount window borrowing is used by federal regulators to keep bankrupt institutions functioning until they can be shut down and their operations taken over by a healthy bank.

Fed officials said the proposed switch to a higher interest rate charge would not eliminate the Fed's function as a lender of last resort. In fact, the Fed proposed creating a second rate level for banks having trouble obtaining short-term loans from other banks that would be 1.5 percentage points higher than the funds rate.

It would mark the biggest change in Fed borrowing operations in about two decades, since Congress in the early 1980s opened the Fed's discount window to all financial institutions, not just banks who are members of the Federal Reserve system.