Fed finds discount window stigma persistent post-crisis

The Federal Reserve Bank of New York released a comprehensive analysis of the stigma associated with the Federal Reserve’s Discount Window (DW) from 2014 to 2024. The report indicates that despite policy changes aimed at encouraging usage, stigma persists, particularly among smaller banks and during periods of financial distress. The study also highlights that the reluctance to use the DW, seen as a lender of last resort, remained notable even months before the 2023 banking turmoil and continued a year after.

The DW provides backup funding to sound depository institutions against various types of collateral. Over the years, the Fed has modified DW policies to promote borrowing and mitigate the stigma. Notably, during the onset of the COVID-19 pandemic in 2020, the Fed cut the primary credit rate to 0.25% and extended loan terms to 90 days, among other changes. Despite these efforts, the stigma has not been fully eliminated.

The report details that small domestic banks with less than $50 billion in assets paid an additional $0.5 billion in excess interest by borrowing federal funds at rates above the DW rate in the year following the failure of First Republic Bank (OTC:FRCB) on May 31, 2023. This occurred even as liquidity markets appeared to normalize, suggesting that stigma was a more expensive and persistent issue for smaller institutions.

The analysis reveals that a bank experiencing stigma is about 40% more likely to do so again the following month. Additionally, banks that visit the DW are less likely to suffer from subsequent stigma. Financial weakness also increases a bank’s susceptibility to stigma, making it a more telling sign of a bank’s failure risk than DW borrowing.

The study also examined DW borrowing patterns after the 2014 period, noting that DW activity was minimal before the COVID-19 pandemic but surged to a peak of $49.8 billion in outstanding loans during the pandemic. The March 2023 banking turmoil saw an even greater spike in DW borrowing, with the amount outstanding at the DW reaching $155 billion. This was significantly higher than during the global financial crisis or the onset of the pandemic.

The evidence of DW stigma was not only confined to the federal funds market but was also present in other funding markets. The report suggests that the stigma was visible around the last three major financial disruptions: the September 2019 repo markets disruption, the onset of the COVID-19 pandemic, and the March 2023 banking turmoil.

The New York Fed’s findings point to the complexity of addressing DW stigma and raise questions about the effectiveness of current policies. The persistence of stigma, especially among smaller banks, suggests that the Fed’s objective of promoting regular DW access “in good times and bad” may face significant challenges. The report concludes that further research is needed to understand why stigma persists and how to effectively reform the DW to encourage its use without the associated stigma.

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