How banks can learn to stop worrying and love the Fed's discount window

Bloomberg News

The Federal Reserve's discount window can be a powerful tool for banks in need of fast liquidity — but only if they've taken the proper steps in advance. 

Silicon Valley Bank and Signature Bank both learned that lesson the hard way in March, as they struggled to pledge collateral to the emergency lending facility in time to stave off crippling deposit runs. 

It is unclear if more preparation would have prevented either bank from failing, but the episode highlighted how dependent the Fed's status as the banking sector's lender of last resort is on banks holding up their end of the bargain. In response, Fed officials are urging banks to test their ability to borrow from the discount window more frequently and even considering making such activity mandatory.

"As the authorities continue to learn from the recent episode, it will be valuable to examine how supervision and regulation can best take operational readiness into consideration," Lori Logan, president of the Federal Reserve Bank of Dallas said in a speech in May. "For example, an expectation that depository institutions establish and periodically test access to the discount window could help make individual firms and the financial system more resilient."

Along with ensuring banks have taken the proper steps to borrow from the discount window — which include identifying eligible securities and having pledge agreement contracts in place with the Fed — Logan said regular testing could also diminish the persistent stigma that banks and market participants associate with using the discount window. 

"If all depository institutions regularly tested their discount window access, the traditional stigmas associated with borrowing from the Fed would be further reduced," she said.

Banks have long avoided using the discount window, even in times of genuine distress, out of fear that doing so would convey weakness to investors, counterparties and depositors. The Fed does not disclose which firms have borrowed from the facility for two years, but banks still dread having to explain the action after the fact to the market or their examiners.

Cliff Stanford, a partner with the law firm Alston & Bird and former chief enforcement lawyer at the Federal Reserve Bank of Atlanta, said there is clearly an effort by regulators to "rebalance the scales" around the use and perception of the discount window. What is less clear, he noted, is how that message is being received and how long that rebalancing process might take.

"There's an effort underway from the Fed to message out to banks that this is important, the lessons learned from what happened with Signature and SVB are real, and let's learn from those together," Stanford said. "Whether that filters down through the ranks and gets messaged in such a way that it overcomes that longstanding stigma remains to be seen. The jury's out on that."

Bowman: Fed reforms should focus on supervision and liquidity, not capital

June 25, 2023 9:30 AM

Along with urging banks to be more proactive and weighing supervisory changes, the Fed is also taking steps that appear aimed at modernizing the discount window. Earlier this month, the central bank quietly disclosed that it would launch a new online application called Discount Window Direct in December that will allow borrowers to "submit requests for advances from the reserve banks, view information on pledges of collateral and communicate with the reserve banks about advances and pledges of collateral." 

The program was announced alongside updated guidelines for discount window use titled "Operating Circular 10." The document, which goes into effect next month, is not an explicit response to recent events, but Stanford said the focus on ensuring banks have eligible collateral pledged to the facility appears to speak to some of the key issues at play in recent failures.

"Reserve banks are very clearly saying, if [a piece of collateral] doesn't work, and we tell you it doesn't work, don't schedule it and assume it does," he said.

In the post-mortem reports on the failures of Santa Clara, California-based Silicon Valley Bank and New York-based Signature Bank, regulators pointed to long gaps in the institutions' discount window testing. 

Silicon Valley did not test its borrowing capacity in 2022, the Fed's report noted, and when the run on the bank's deposits started, it did not have "appropriate collateral and operational arrangements in place to obtain liquidity." Fed staffers attempted to help the bank sort out its issues on March 8, but were ultimately unsuccessful in transferring collateral from the company's custody bank or its account at the Federal Home Loan Bank of San Francisco before the bank was shuttered the morning of March 10. 

Having assets properly situated at the discount window likely would not have been enough to stave off the run — in which $40 billion left the bank's coffers on March 9 and another $100 billion were poised to be withdrawn the following day — but the Fed's report concluded that "the lack of preparedness may have contributed to how quickly it failed."

Similarly, Signature had not tested its discount window capabilities in five years. Richard Ostrander, general counsel and head of the legal group at the New York Fed, said in a speech last month that the bank's staff "did not understand the discount window collateral eligibility and diligence standards." He added that the bank had become "too reliant" on the Federal Home Loan Bank of New York as a contingency funding source.

The Federal Home Loan Bank System is a source of collateralized borrowing that eligible banks tend to turn to more readily when they need liquidity. Unlike discount window loans, Federal Home Loan bank advances do not come with a penalty rate or market stigma. 

Federal Home Loan bank borrowing has increased sharply since the end of 2021, closing that year at $335 billion before rocketing to more than $1 trillion at the end of the first quarter of this year. Discount window usage, which is reported weekly, peaked at $150 billion in March — driven largely by the cost of temporarily absorbing two failed banks — and has steadily fallen to just a few billion. 

Despite the similarities of the two liquidity sources, there are some key differences that came to the fore this spring. First, banks must purchase stock from their regional home loan bank to get an advance. Federal Home Loan banks also cap how much credit they are willing to extend to each member bank. More critically, the Federal Home Loan banks and the Fed have different criteria for the collateral they will accept. 

To get the eligible collateral that Signature posted at the Federal Home Loan Bank of New York, Ostrander said the New York Fed had to work with the two entities to create a subordination and pledge arrangements that gave the reserve bank a "perfected priority security interest" without actually transferring the securities. 

Ostrander noted that other banks should not count on this type of intervention coming through in a pinch. Instead they "must take ownership of their operational preparedness before a liquidity crisis occurs," he argued.

"At a minimum, banks should conduct tabletop exercises to identify gaps in their capabilities. Banks should refamiliarize themselves with the requirements to access the discount window," Ostrander said. "Most important, I urge banks to take the extra step of exercising these borrowing capabilities regularly to facilitate access to funds should the need arise."

Mayra Rodriguez Valladares, an independent consultant who advises both banks and regulators on regulatory matters, said there is precedent for compelling banks to conduct exercises to test their emergency readiness. She pointed to a provision of the liquidity capital ratio under which supervisors can compel banks to sell high-quality assets to demonstrate how they would do so in a time of distress.

"They should test periodically to make sure that if they do need to access the discount window they can," Rodriguez Valladares said. "If they can't even do that, then they seriously have some kind of a process problem or some kind of psychological problem that should be addressed. You don't want a situation where, indeed, there is an emergency and they can't get this done."

There are some signs that banks' approaches to the discount window are evolving. In May, Phoenix-based Western Alliance Bancorporation highlighted its discount window borrowing capabilities — which totaled $16.2 billion as of March 31  — in an investor presentation. Though it is unclear whether this represents a permanent shift or merely an attempt to demonstrate the wide range of funding sources available to the bank in times of stress. A spokesperson for Western Alliance declined to comment on its communication strategy around discount window usage.

Derek Tang, co-founder of the Washington-based research firm Monetary Policy Analytics, said bank attitudes about the discount window are changing, but slowly. 

"That stigma hasn't gone away. It's just that the stigma of a failing bank is probably worse," Tang said. "You just have to pick your poison."