WASHINGTON - Borrowing at the discount window, for decades a contingency to avoid at almost any cost, is no longer taboo.
Really.
Six months after the Federal Reserve Board made changes meant to encourage bankers to use the window more often, regulators last week issued new guidance - perhaps a sign that the program is not drawing many takers.
"Occasional use of primary credit for short-term contingency funding should be viewed as appropriate and unexceptional," the Fed said in a joint press release with the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the National Credit Union Administration.
The old policy generally kept bankers away from the window unless they had nowhere else to go. Yet there's no indication they have gotten the new message.
"I still think there is some reluctance on the part of banks to go to the discount window," said Sung Won Sohn, the chief economist at Wells Fargo & Co. "For decades and decades ... no bank wanted to be known as a bank that went to the discount window, and I don't think that has disappeared."
In the past banks facing reserve shortfalls could go to the window and borrow at below-market rates, usually 50 basis points below the federal funds target. In most cases, the shortfalls were the result of relatively minor operational errors and miscalculations, and they usually did not signal fundamental safety-and-soundness concerns.
Still, the Fed would ask the potential borrower a lot of questions to make sure that it had exhausted all other funding options, and that was a powerful disincentive against using the window. It meant that a bank had to be turned down by other potential lenders - possibly including some of its competitors - before the Fed would step in.
The new system establishes a primary credit program under which banks may borrow at a rate fixed at 100 basis points above the federal funds target. The above-market rate was a response to criticism that the discount window amounted to subsidized lending. It also eased the administrative burden, because healthy banks can now borrow at the primary facility with no questions asked.
(Banks with a Camels rating lower than 3 can still get credit through a secondary program, at a rate fixed at 50 basis points above the primary one, but borrowers under that program still face Fed scrutiny. The Fed also continues to offer seasonal credit to banks - typically agricultural lenders - that can demonstrate big swings in their funding requirements.)
"When you have a subsidy rate, you spend a lot of time trying to administer it," said Oliver Ireland, a lawyer with Morrison & Foerster here. "You have to have your hand on the tap and regulate the amount that goes out and make sure people have an appropriate use for it. When you go to an [above-market] rate, you have to do a lot less."
The change also helps the Fed meet broader goals, not the least of which is restoring efficiency to financial markets and the payment system in the event of a serious disruption.
"The post-9/11 disruption in funding markets was in the Fed's view exacerbated by the stigma attached to discount window borrowing," said Karen Shaw Petrou, the managing partner of Federal Financial Analytics here. The new system "makes it easier for institutions to get contingency funding without sending a market signal of distress."
Moving to the new system also serves the Fed's monetary policy goals.
By tying the discount rate to the federal funds target - and not to the federal funds rate itself - the Fed hoped to bring more discipline to that market. Under the old system, the federal funds rate could swing wildly and move percentage points above the target. The volatility would be at its worst near the end of periods in which regulators measured reserves.
"At the end of a reserve-maintenance period, banks are scrambling around to borrow funds to satisfy reserve requirements, and that rate can really escalate," said Gil Schwartz, a partner with the law firm Schwartz & Ballen here. "Monetary-policy reasons were a strong incentive" to change the discount window program. "It puts a cap on the fed funds rate, because once the fed funds rate goes up to what the discount rate is, banks will start borrowing from the Fed, and that will drive the fed funds rate back down."
Bert Ely, an independent consultant in Alexandria, Va., said the Fed is trying "maintain the credibility" of the federal funds target. "This helps to maintain the credibility by holding down the volatility of the actual rate."
Bankers say they are aware of the new policies and the guidance put out last week, but given the healthy state of the industry and the flood of deposits that have made banks so liquid, the new system has not yet been put to the test.
Weekly balances at the discount window, which were frequently in the hundreds of millions of dollars when the industry was under duress in 1989 and 1990, have plunged. The median weekly balance since the Fed instituted the primary credit system in January is under $8 million.
"I don't think people have focused on any change in their view of what the discount window is all about," Mr. Schwartz said. "I think it will come up in the context of whenever there is a shortfall and real pressure from a liquidity standpoint. That's when banks will change their view of the world."
Mr. Sohn of Wells Fargo agreed with that prediction. "Liquidity been so plentiful for the last six months, no one really needed to go the discount window," he said.
Some banks say they are willing to use the window when the need arises.
"While we view the Fed discount window as a viable source of liquidity, we have multiple alternative funding sources that are comparatively less expensive," said A.C. McGraw, a spokeswoman for BB&T Corp. in Winston-Salem, N.C. "However, if market conditions were such that the Fed became the most cost-effective alternative, we would not hesitate to use it."
Michael Piemonte, a spokesman for M&T Bank Corp. in Buffalo, said the industry's view of the discount window is evolving.
"Everybody got much more up to speed on what was going on with the Fed's discount window with 9/11 and Y2K," he said. "For our liquidity policies it used to be kind of an afterthought. You never went there."
Under the new system, however, "there may be less of a stigma attached to it," he said. "That's something we'll have to wait and see how the market reacts."
Mr. Schwartz said the federal funds rate is an obvious litmus test of whether banks are acting on the Fed's new message.
"If you continue to see the volatility in the fed funds rate - meaning the fed funds rate goes above the posted discount rate - then that means the stigma is still there, that banks are just not paying attention to the discount rate."
