What Is the Discount Rate?
The discount rate, also known as the Fed discount rate, is the interest rate charged to commercial banks and other institutions on loans from a Federal Reserve bank. This process is a key tool of Federal Reserve monetary policy and an integral part of the Federal Reserve’s role in the broader financial system.
Although commercial banks are allowed to borrow money from each other for short term purposes through a market-driven facility based on the interbank rate, they are also allowed to borrow from the Federal Reserve through the “discount window.”
Banks use this money for very short-term operating requirements, such as temporary funding shortfalls, regulatory liquidity requirements, and, in the most extreme cases, to prevent bank failure.
How the Discount Rate Works
The Fed grants loans from the discount window for an extremely short period of time, usually 24 hours or less. In contrast to the interbank rate, the discount rate is not a market rate and instead is set and approved by the Federal Reserve Bank’s Board of Governors. Also in contrast to the market-driven interbank rate, loans made through the Fed discount window require collateral.
Three Tiers of Discount Rate Loans
Like a commercial bank lending to a consumer, the Fed’s discount window charges different discount rates based on the credit quality of the borrowing bank and offers three types or tiers of loans.
The first tier is the Primary Credit program. This is the best rate and is offered to the most financially sound institutions.
The second tier is referred to as the Secondary Credit program. This rate is offered to institutions that do not qualify for the Primary credit program and is priced 50 basis points (bps) higher than the Primary Credit rate.
The third tier is known as the Seasonal Credit program. This tier serves smaller institutions whose cash flow fluctuates based on seasonal or geographic trends, for example, banks located in rural, agricultural markets or areas heavily dependent on seasonal tourism. This rate is higher than the Primary and Secondary programs as these institutions are riskier, and is influenced by market conditions.
Federal Funds Rate vs. the Discount Rate
The Federal Funds Rate is the interest rate banks charge each other on loans used to meet capital reserve requirements. The discount rate is the rate charged at the Fed’s discount window for institutions to borrow from the Fed in order to meet short-term liquidity needs.
The Fed Funds rate is typically 25 basis points (bps) lower than the discount rate. The Federal Reserve sets the discount rate and sets a target rate for the Fed funds rate, which is then negotiated by the banks involved in each loan.
History of the Discount Rate
Created in 1913, along with the Federal Reserve System, the discount rate is one of the Fed’s monetary policy tools and enables the central bank to lend to financial institutions. The discount window facility fulfills the Fed’s role as a lender of last resort when banks cannot find lenders in the open market. Historically, banks try to use the discount window sparingly to avoid the perception that they must be in trouble.
Use of the Fed’s discount window increased markedly leading up to and during the financial crisis of 2008 as financial conditions deteriorated. During this period, the Federal Reserve Board also extended the loan period from overnight to 30 days and then to 90 days in order to maintain liquidity in the U.S. banking system. Once the crisis passed, these temporary measures were revoked.