Discount Window
What is Discount Window?
The discount window is the facility through which a central bank lends directly to banks against collateral, at a rate it sets itself.
A bank short of cash for a day can pledge collateral at the central bank and borrow at the discount rate instead of dumping assets or scrambling in the overnight market. Because that rate is normally set above the target for interbank lending, the window doubles as a ceiling: no bank should pay much more to borrow from another bank than the central bank charges. Its second job is emergency liquidity, since this is the channel that keeps a solvent but illiquid bank from being closed by a run. The practical weakness is stigma, because borrowing can be read as a sign of distress, so banks avoid the window exactly when it would help most. Unlike open-market operations, which change reserves for the whole system, a discount loan goes to one named institution.
Discount Window: a worked example
A bank loses $200 million of deposits in a single day. It owns government bonds it could sell, but a forced same-day sale would go through at about 2 percent below face value, a cost of roughly 200,000,000 × 0.02 = $4 million. Instead it pledges those bonds at the discount window and borrows the $200 million overnight. If the discount rate is 4 percent, one night costs 200,000,000 × 0.04 ÷ 365, or about $21,900. The bank repays the loan the next day when its own inflows arrive, and the fire sale never happens.
The mistake students make with discount window
Students mix up the discount rate with the federal funds rate and assume the discount rate is the main policy lever. The discount rate is what the central bank charges on its own direct loans and is normally set above the interbank target, so it works as a ceiling rather than as the tool that sets the target. Banks do most of their overnight borrowing from each other, and turn to the window when that market fails them.
Discount Window questions
What is the difference between the discount rate and the federal funds rate?
The discount rate is what a central bank charges banks that borrow from it directly, while the federal funds rate is what banks charge each other for overnight loans of reserves. The discount rate is administered by the central bank and normally sits above the federal funds target, which makes it a ceiling on what banks will pay in the interbank market.
Why do banks avoid borrowing at the discount window?
Banks avoid the window because of stigma: if word gets out that a bank borrowed there, lenders may read it as evidence the bank could not fund itself normally. Central banks fight the stigma by encouraging healthy banks to borrow routinely, keeping the terms attractive, and delaying the disclosure of who borrowed.
Why is the discount rate set above the target interbank rate?
The discount rate sits above the interbank target so the window acts as a backstop rather than a cheap first stop. If it were below the market rate, banks would borrow from the central bank and lend the proceeds out at a profit, and the central bank would end up funding the market rather than backstopping it.
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