What it is:
The discount window is the method that banks use to borrow money from a central bank on a short-term basis, named after an actual teller window at the Federal Reserve where such transactions used to be carried out. The discount window is used only in financial emergencies, such as major stock market collapses or liquidity crises.
How it works (Example):
The banking system is designed to provide sufficient capital to ensure that banks can conduct transactions on a daily basis. This includes taking deposits, paying interest and extending credit. These activities are crucial to business and are the banks' source of income.
In theory, banks are supposed to balance their deposits, capital reserves and credits to ensure liquidity and keep sufficient funds on hand to meet their immediate needs. In practice, however, banks often borrow from one another in order to meet their short-term needs, taking advantage of high-speed electronic transfers of funds between banks to exchange reserves or deficits as needed. In the United States, these inter-bank transactions are regulated by the Federal Reserve (the nation's central bank) and carry an interest rate called the "federal funds rate"
In emergency circumstances, such as when banks are unable or unwilling to lend money to each other, they are permitted to borrow money from the central bank directly on a short-term basis. These direct, short-term loans from the central bank are provided through the discount window. The interest rate they are charged on these loans is called the "base rate." These loans normally carry an interest rate of 100 basis points (1%) above the federal funds rate and have a one-day term. the Fed funds rate is not fixed and is set by the market.
Why it Matters:
While in normal circumstances the discount window is not a major monetary policy tool, it is “opened” in times of economic disruptions, usually liquidity crises, major market collapses or disasters. The 2008 international banking crisis led the Fed to extend credit through the discount window for up to 90 days and at a reduced base rate. The Fed stepped in to provide direct loans through the discount window to try to provide the necessary liquidity so that banks could continue doing business.