Academic journal article ABA Banking Journal

Is the Fed's Discount Window Proposal Justified? (the Economy)

Academic journal article ABA Banking Journal

Is the Fed's Discount Window Proposal Justified? (the Economy)

Article excerpt

THE FEDERAL RESERVE RECENTly proposed a new alternative short-term borrowing mechanism for banks, in an attempt to lower the volatility of the federal funds rate during the end of the reserve adjustment period. Ironically, our latest analysis reveals that just as the Fed has started to focus on this topic, federal funds rate volatility has started to decline. However, the real reason for this procedural change is to lower the volatility of the fed funds rate towards the end of the reserve adjustment period when many financial institutions are forced to scramble to meet their reserve requirement needs. Along this line of reasoning, we were able to find some support for the proposed change, since volatility was found to be over 50% higher on average during the last day of the reserve adjustment cycle compared to the whole two-week period.

Banks must keep a required level of reserves against their deposit base over individual two-week intervals. To alleviate excessive volatility towards the end of the period, the Fed proposed a new type of discount window credit called "primary credit." At present, banks can borrow from the discount window (i.e., adjustment credit) with some administrative constraints at an interest rate that is below the current targeted federal funds rate. Under the new procedure, no such constraints will be imposed because banks will he able to borrow at a so-called penalty rate of 100 basis points over the fed funds target rate.

Although many analysts have focused on whether this penalty rate is too onerous, our goal was to see whether such a change is justified by the data in the first place. …

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