Regulators Discuss Liquidity Risk Management, Operational Readiness, and the Federal Reserve’s Discount Window

The discount window currently is in focus for the federal banking agencies. Reflecting on the turmoil relating to the failures of three large banking organizations in the spring of 2023, officials at the banking agencies have highlighted the importance of liquidity risk management and bank operational readiness for use of the Federal Reserve’s discount window.

This Advisory offers a short primer on the discount window and a discussion of recent policymaker remarks about it, while also summarizing the Federal Reserve’s discontinuance of the Bank Term Funding Program (BTFP). As highlighted by Federal Reserve Vice Chair for Supervision, Michael S. Barr, and Acting Comptroller of the Currency, Michael J. Hsu, banks should consider their discount window readiness prior to acute stress events. Acting Comptroller Hsu also suggested the possibility of a new short-term liquidity requirement.

The Federal Reserve’s Discount Window: A Primer

Under Section 10B of the Federal Reserve Act, the Federal Reserve may extend credit, generally on either an intraday or overnight basis, to depository institutions chartered in the United States, as well as U.S. branches of foreign banking organizations.¹ Discount window lending occurs at each of the twelve Federal Reserve Banks through three main lending programs: primary credit, secondary credit, and seasonal credit.

• Primary Credit. Primary credit is generally available to all sound depository institutions, as determined by the relevant Federal Reserve Bank, using information from their primary regulator, on a short-term basis, usually overnight, and as backup liquidity. According to the Federal Reserve, it is not intended as a regular source of funding.
• Secondary Credit. For those depository institutions not eligible to access primary credit, secondary credit may be extended on a short-term basis, usually overnight. Subject to more restrictions than primary credit, these loans also come with higher rates and higher haircuts.
• Seasonal Credit. Under the seasonal borrowing program, a depository institution with deposits of less than US$500 million and demonstrated liquidity pressures may qualify for funding for up to nine months of the calendar year.²

Operating Circular No. 10 sets forth the terms and procedures under which Federal Reserve Banks extend credit through the discount window to depository institutions. It also forms the lending agreement for Federal Reserve Bank advances. Notably, all loans must be secured by collateral acceptable to the appropriate Federal Reserve Bank and all discount window loans must be fully secured. Borrowers may contact the discount window staff at their applicable Federal Reserve Bank with questions.³

The Federal Reserve discloses discount window loans in the aggregate on a weekly basis and discloses individual borrowers on a one-year lag.⁴ Stigma has been a long-running issue for discount window usage.⁵

Winding Down the Bank Term Funding Program

On March 12, 2023, the Federal Reserve Board announced the creation of the BTFP, offering loans to depository institutions that pledged U.S. treasuries, agency debt, and agency mortgage-backed securities as collateral. Unlike the regular discount window, pledged assets were valued at par and were offered for terms up to one year. Authorized under Section 13(3) of the Federal Reserve Act, the BTFP was designed to assure the public that banks would have sufficient liquidity to safeguard deposits.⁶ As originally scheduled, the Federal Reserve Board has confirmed that the BTFP will cease making new loans to eligible depository institutions on March 11, 2024.⁷

Remarks by Vice Chair for Supervision Michael S. Barr

In December, Federal Reserve Vice Chair for Supervision Michael S. Barr advised the banking sector that discount window access should figure prominently into liquidity risk management plans. Barr’s remarks echo that of other Federal Reserve officials and recent interagency liquidity guidance.⁸

Barr suggested that there are two key aspects to discount window readiness. First, banks must be prepared to access the discount window by ensuring they have the appropriate legal agreements in place, of which most do. Moreover, banks should engage in discount window testing through actual transactions in regular intervals. Most have not, observed Barr.

Second, banks should pre-position an adequate amount of collateral at the discount window. Noting that certain types of collateral may require additional time to pledge, Barr warned against bank expectations of immediate liquidity at the discount window, particularly for less liquid collateral.

Barr stated that the events of the spring showed that banks could have had greater operational readiness to use the discount window, suggesting that there were operational challenges in quickly identifying and moving collateral to pledge. Barr advised that the lessons from the stress events of last spring could help other banks when facing less acute events.

Barr also underlined that use of the discount window will not be viewed negatively. Rather, Barr identified the discount window as an important tool that banks should be ready and willing to use in both good and bad times. And given the speed of bank runs, Barr noted that “it may be necessary to reexamine our requirements,” including “discount window preparedness.”

Remarks by Acting Comptroller Michael J. Hsu

In January, Acting Comptroller of the Currency Michael J. Hsu gave a speech in which he sounded similar notes as Vice Chair Barr about the need for readiness to use the discount window, including identification and pre-positioning of collateral. In addition, he suggested that a new liquidity measure, requiring midsize and large banks to have sufficient liquidity to cover outflows over a five-day period, warrants serious consideration. According to Hsu, the numerator of this measure "should consider" the liquidity value of pre-positioned discount window collateral, in addition to reserves, while the denominator "should consider" uninsured deposit outflows. He advised that this same rule should also clarify operational preparedness expectations by the prudential regulators and perhaps even include a requirement to conduct periodic test draws at the discount window.

Hsu’s proposal hopes to address two hurdles related to discount window access. First, Hsu suggested that there exists a discrepancy between the timing during which depositors can make withdrawals and banks can monetize assets. To account for the speed at which withdrawals can be made, Hsu suggested banks identify assets that can be pre-positioned and pledged at the discount window. Moreover, Hsu advised that banks periodically borrow from the discount window to ensure operational familiarity.

Second, Hsu suggested that his proposal could help to combat the stigma surrounding discount window borrowing. Despite regulatory pushback, Hsu noted that banks continue to worry that news of discount window lending could be perceived as a sign of weakness, which in turn may exacerbate a bank run.

Although Hsu emphasized the need to destigmatize use of the discount window, he also warned against inappropriate overreliance. For Hsu, a new regulatory rule could provide the space to balance appropriate discount window usage while maintaining “anti-bailout conservatism.”

Takeaways

Facilitating the flow of credit to the economy, the Federal Reserve’s discount window will continue to serve as an important tool for banks as the speed of banking and finance accelerates. The speed of the events of the spring seem to have renewed regulatory interest in short-term liquidity risk management and operational readiness.

Independently, the Group of Thirty (G30), a body comprised of eminent current and former economic and financial leaders, recently published a high-profile report on lender of last resort regimes as well.⁹ The G30 made recommendations about how the discount window in the U.S. could be made more efficacious, including recommendations about pricing, stigma, and the mandatory pre-positioning of collateral sufficient to cover runnable liabilities. The G30 report is a demonstration that there may be continuing evolution in this space in the years ahead.

Institutions interested in how liquidity risk management or operational readiness of the Federal Reserve’s discount window may impact their businesses may contact any of the authors of this Advisory or their usual Arnold & Porter contact. The firm’s Financial Services team would be pleased to assist with any questions about the discount window, or financial regulation more broadly.

© Arnold & Porter Kaye Scholer LLP 2024 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.