Economists call for destigmatizing Fed discount window lending

WASHINGTON, Feb. 15 (UPI) -- Economists at a hearing Thursday promoted increased use of the Fed's discount window -- which helps commercial banks manage short-term liquidity needs -- to insulate the economy from risks of financial crisis.

"The discount window ... has always been the banks' first line of defense against broader financial turmoil," William Nelson, chief economist at the Bank Policy Institute, said during the House Subcommittee on Financial Institutions and Monetary Policy hearing.

Discount window lending is one of the Fed's lender of last resort functions for banks that are unable to borrow from other banks. Banks that borrow directly from the central bank pay the federal discount rate.

The Fed lends to solvent financial institutions at the discount window against good collateral. Otherwise, the Fed is licensed under the Federal Reserve Act to make emergency loans in "exigent" situations.

"Many banks now refuse to borrow under any circumstances, except perhaps an obvious glitch affecting the entire payment system," Nelson said, pointing a finger at the stigma in obtaining a loan.

Hal Scott, a Harvard University professor of International Financial Systems, said the Fed's lender of last resort function should be conducted primarily through the discount window and minimized in emergency lending.

The panicked mindset that underlies financial crises contributes to the stigma, Scott said.

People think irrationally, "If this bank fails, every bank is going to fail -- I'm getting my money out," he said.

Under the 2008 Dodd-Frank Wall Street Reform, which was enacted to crack down on financial risk-taking, the borrowing behavior of banks was obscured from the public for two years.

Nelson suggested a return to this system could reduce the stigma for banks using the discount window.

However, Simon Johnson, professor of entrepreneurship at the MIT Sloan School of Management, cautioned that keeping borrowing secret would be "problematic" since the ability to borrow from the Fed already is exclusive to banks.

Reps. Bill Foster, D-Ill., and Blaine Luetkemeyer, R-Mo., acknowledged that social media, artificial intelligence and 24-hour banking will only accelerate bank runs by amplifying market behavior fluctuations and facilitating rapid deposit withdrawals.

"We live in a different world where this instantaneous ability to do things today is such that we've got to be able to instantaneously react," Luetkemeyer said. "If we don't, I'm fearful."

The vulnerabilities of the financial system were stripped bare last March with the collapse of the Silicon Valley Bank, the third-largest bank failure in the United States.

Witnesses on Thursday called attention to that financial crisis in asking that the Fed develop policies to destigmatize lending at the discount window.

"The lack of capital or potential insolvency is absolutely intertwined with issues of liquidity pressure in many financial crises, and it was absolutely with Silicon Valley Bank," Johnson said.

To mitigate the contagion effect that can snowball into a full-scale bank run, the Fed could provide more financial support to prop up capsizing banks, experts said.

The Fed used emergency lending to bail out institutions after the Global Financial Crisis, the COVID-19 recession and most recently, the Silicon Valley Bank collapse with the Bank Term Funding Program.

Expanded use of emergency lending leads banks to think the Fed will open a new lending facility to bail them out, according to Nelson.

"The safety net is expanding," he said.

The discount window should be used instead as a liquidity crutch for undercapitalized banking institutions, Nelson said in an interview with Medill News Service.

"We want banks to see this as a tool they can use. We encourage them to count that potential access is one of the ways that they meet their liquidity contingencies," he said. "This is not a bailout. This is not an indication that the bank is in trouble."