Anna J. Schwartz

Anna J. Schwartz is a Senior Research Fellow at The NationalBureau of Economic Research. This paper was the sixth annu-al Homer Jones Memorial Lecture, which was presented at StLouis University on April 9, 1992. The views expressed arethose of the author and do not reflect official positions of theBoard of Governors of the Federal Reserve System or the Fed-eral Reserve Bank of St. Louis.

The Homer Jones Memorial Lecture is an annual eventsponsored by the St. Louis Gateway Chapter of the NationalAssociation of Business Economists in conjunction withWashington University St. Louis University, the University ofMissouri-St. Louis and the Federal Reserve Bank of St. Louis.

Author’s note: For sharing his knowledge of Federal Reservepractices, Walker F Todd has been immensely helpful to me,but he is not responsible for the views I express in this paperI have also benefited from comments by Allan H. Meltzer

The Misuse of the Fed’sDiscount Window

Uit AM HONORED to have the opportunity togive the Homer Jones Memorial Lecture. Inremembering him today, I pay tribute to hiscontributions to monetary policy making and toquantitative monetary research in his capacityas director of research at the St. Louis Fed. Igot to know Homer during the period of hismembership in the Shadow Open Market Com-mittee. At our meetings he was diffident abouthis knowledge and insistent on scrupulous at-tention to statistical evidence as backing for thepolicy conclusions we reached. I cannot think oftwo more admirable qualities in an economist. Itwas a privilege for me to have had this associa-tion with Homer.

In 1925 the Federal Reserve Board collecteddata on the number of member banks continu-ously indebted to their Reserve Banks for atleast a year. As of August 31, 1925, 593 mem-ber banks had been borrowing for a year ormore. Of this number, 239 had been borrowingsince 1920 and 122 had begun borrowing beforethat. The Fed guessed that at least 80 percent of

the 259 national member banks that had failedsince 1920 had been “habitual borrowers” priorto their failure. Of 457 continuous borrowers in1926, 41 banks suspended operations in 1927,while 24 liquidated voluntarily or merged (Shull1971, 34-35).

The reason for citing these statistics for the1920s is to call attention to an early episode inFederal Reserve history that contravened theancient injunction to central banks to lend onlyto illiquid banks, not to insolvent ones, and thatis eerily similar to a current episode. The Fedapparently learned little from the earlier epi-sode, since there is even less justification forthe use made of the discount window in thecurrent t.han in the earlier episode.

The current episode came to light after theHouse Banking Committee requested data on allinsured depository institutions that borrowedfunds from the discount window from January1, 1985, through May 10, 1991. Regulatorsgrade banks on their performance, according to

a scale of I to S. The grades are based on fivemeasures known by the acronym of CAMEL,for Capital adequacy, Asset quality, Manage-ment, Earnings, Liquidity) The Federal Reservereported that of 530 borrowers from 1985 onthat failed within three years of the onset oftheir borrowings, 437 were classified as mostproblem-ridden with a CAMEL rating of 5, thepoorest rating; 51 borrowers had the nextlowest rating, CAMEL 4. One borrower with aCAMEL rating of 5 remained open for as longas 56 months. The whole class of CAMEL5-rated institutions were allowed to continueoperations for a mean period of about one year.

At the time of failure, 60 percent of the bor-rowers had outstanding discount window loans.These loans were granted almost daily to insti-tutions with a high probability of insolvency inthe near term, new borrowings rolling overbalances due. In aggregate, the loans of thisgroup at the time of failure amounted to $8.3billion, of which $7.9 billion was extended whenthe institutions were operating with a CAMEL 5rating. Three months prior to failure, borrow-ings of all 530 institutions peaked at $18.1 bil-lion. Rather than encouraging banks to pursuestrategies to preserve their size, regulators oftenencourage institutions that are about to fail toshrink drastically first, so as to diminish thepool of assets that have to be liquidated afterclosing.

Some observers of bank performance have as-serted that it is impossible to know whether aninstitution that applies for discount window as-sistance faces a liquidity or solvency problem.That assertion may be defensible for discountwindow lending in the 1920s even though anestimated 80 percent of long-time borrowers

failed, since CAMEL ratings did not then exist.Currently, CAMEL ratings 4 and 5 are knownpromptly. Why should it be impossible or evendifficult to distinguish between an illiquid andan insolvent bank?

Support by the Fed for banks with a highprobability of insolvency in the near term is notthe only recurrent problem with the discountwindow. Equally troublesome is the history ofactual or proposed Fed capital loans to non-banks. Such use of the discount window dis-tracts the Fed’s attention from its monetarycontrol function. Recent experience reinforcesearlier doubts about the need for the discountwindow. The time has come for a truly basicchange: eliminate the discount window and re-trict the Fed to open market operations.2 Thischange would have the added value of obliterat-ing the symbolic role of the discount rate andweakening the tendency to regard the Fed asdetermining interest rates.

In the rest of this paper, I document the ero-sion of the historic restriction, at least since the1930s, of Federal Reserve discount window assis-tance to liquidity-strained banks on the securityof sound assets. Section 1 deals with lendingoperations from the founding until the post-World War II period, during which loans tononbanks first occur. I then discuss FederalReserve actions in recent decades that have fur-ther blurred the distinction between liquidityand solvency, and also the emergence of variousnonbanks as candidates for discount window as-sistance. I ask why these developments have oc-curred when there has been no change in officialdeclarations of commitment to supply only li-quidity, not solvency or capital, to individualbanks, not nonbanks (section 2). In the next sec-

‘Brief official descriptions of composite CAMEL 4 and 5 rat-ings follow:

CAMEL 4 “Institutions in this group have an immoder-ate volume of serious financial weaknesses or a combi-nation of other conditions that are unsatisfactory. Majorand serious problems or unsafe and unsound conditionsmay exist which are not being satisfactorily addressed orresolved.”

CAMEL 5 “This category is reserved for institutionswith an extremely high immediate or near-term probabilityof failure.”

CAMEL ratings of banks are not uniform from one districtto another. Some New York CAMEL 4 banks may be rated5 elsewhere.

2This recommendation has been disputed on the groundthat establishing access to the discount window as a right— not a privilege — administered at a penalty rate wouldsolve the problems that face the current administration ofthe window. It is not clear to me, however, that these

changes would eliminate the problem of political pressureson the Fed to lend to nonbanks. As for the problem ofloans to insolvent banks, access to the window as a rightat a penalty rate might only result in worsening adverseselection.

See also Kaufman (1991), who argues that the discountwindow is not needed to protect the money supply — thebasic justification for a lender of last resort — and that li-quidity strains can be mitigated by open market operationswithout involving the Fed in discount window assistance.Credit-worthy banks can borrow at market rates, large onesin the Fed Funds market, small ones from their correspon-dent banks.

tion I examine the costs of Federal Reserve sup-port for problem institutions that regulatoryauthorities eventually close and for nonhanksthat would otherwise have to meet a markettest (section 3). Finally, I consider whether re-forms of discount window practices that havebeen proposed could remedy the inherentproblems of the mechanism. I comment on pro-visions in the FDIC Improvement Act of 1991that may be worthy reform proposals but donot address these problems (section 4). 1 offermy conclusions in section 5.

Regulation A—the first one adopted by theFederal Reserve Board at its creation, in recogni-tion of the expectation that the discount windowat Federal Reserve Banks would serve as themain purveyor of member bank reserves—establishes the rules under which the Banksmay extend credit. Periodically revised, the regu-lation has consistently set out the proceduresthat banks had to follow to gain access to thediscount window. The initial regulation provid-ed for rediscounting short-term agricultural, in-dustrial, and commercial paper, defined aseligible paper. Later, to accommodate Treasuryfinancing needs in World War I, the ReserveBanks were empowered to extend direct col-lateral loans to member banks, occasionally se-cured by pledge of eligible paper but usually byobligations of the U.S. government. Until the1930s, even though the Federal Reserve had be-come familiar with open market purchases as asource of member bank reserves, bills discount-ed usually exceeded U.S. government securitiesin Reserve Bank portfolios.

The discount window provided accornmoda-tion for periods up to 90 days for a non-agricultural discount or advance collateralizedby eligible paper or government obligations, hutof up to nine months for agricultural paper. Asnoted earlier, continuous borrowing year in andyear out in the 1920s was not uncommon. Alater (1954) Federal Reserve document, deploringcontinuous borrowing, noted that “it was possi-ble by the mid-Thirties to speak of an estab-lished tradition against member bank relianceon the discount facility as a supplement to itsresources” (Shull 1971, 41). A similar statement

appears in an internal Federal Reserve historyof the discount mechanism: “extended borrow-ings by a member bank from its Reserve Bankwould in effect constitute a use of FederalReserve credit as a substitute for the member’scapital” (Hackley 1973, 194). The 1973 versionof Regulation A states, as a general principle,that “Federal Reserve credit is not a substitutefor capital and ordinarily is not available for ex-tended periods.” Both the 1980 and 1990 ver-sions of Regulation A state, as a general require-ment, that “Federal Reserve credit is not a sub-stitute for capital.”

A broader statement of the foregoing princi-ple, covering banks and nonbanks, appeared in1932 in a conference report by representativesof the Federal Reserve Bank of New York, whohad met with South American central banks:“Central banks must not in any way supply cap-ital on a permanent basis either to memberbanks or to the public, which may lack it forthe conduct of their business” (Federal ReserveBulletin 1932, 43).

Legislative changes in the administration ofthe discount window, made in response to bankfailures in the Great Depression, sometimes ob-served this advice. The Glass-Steagall Act ofFebruary 27, 1932, authorized Federal ReserveBanks (in a new section 10(b) added to the Fed-eral Reserve Act) to make advances to memberbanks on their promissory notes secured byotherwise ineligible collateral, if acceptable tothe Reserve Banks, for periods up to four monthsat rates not less than one-half percent per an-num above the prevailing highest discount rate.No provision was made for solvency loans ofcapital or loans to receivers of closed banks.

Although no provision was made for solvencyloans of capital, the Emergency Relief and Con-struction Act of July 21, 1932 (in a new section13(3) added to the Federal Reserve Act), openedthe discount window to nonbanks. It permittedthe Reserve Banks to discount for individuals,partnerships and corporations, with no othersources of funds, notes, drafts and bills of ex-change eligible for discount for member banks.The New Deal confirmed this type of authority(in section 403 of Title III of the EmergencyBanking Act of March 9, 1933, that added section13(13) to the Federal Reserve Act). It allowed90-day advances to individuals, partnerships andcorporations on the security of direct obliga-tions of the U.S. government, at interest r’atesfixed by the Reserve Banks.

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Before turning to the New Deal change thatinvolved Reserve Banks in extending capitalloans to nonbanks, let me review the otherchanges in the Emergency Banking Act of 1933.

Title II created conservatorships for nationalbanks. Section 304 of Title Ill authorized theReconstruction Finance Corporation, not theFederal Reserve, to subscribe to preferred stock“of any national banking association or anyState bank or trust company in need of fundsfor capital purposes.” It is significant that TitleIV, referring to the Federal Reserve, conferredon it no authority to make solvency loans ofcapital. Section 402 authorized Federal ReserveBanks, until March 3, 1934, to make advances inexceptional and exigent circumstances to mem-ber banks on their own notes on the security ofany acceptable assets, superseding the provisionregarding advances to member banks in theFebruary 1932 Glass-Steagall Act. By Presidentialproclamation, this provision, the forerunner ofthe present section 10(b), was extended untilMarch 3, 1935, when it expired (Board AnnualReport 1933, 261-265). The new form of section10(b) became permanent as part of the BankingAct of 1935.

I now turn to the New Deal change thatauthorized the Federal Reserve to make solvency/capital loans to nonbanks. The Act of June 19,

1934, added a new section 13(b) to the FederalReserve Act, which authorized Reserve Banksdirectly or in participation with a member ornonmember bank to make advances to estab-lished commercial or industrial enterprises forthe purpose of supplying working capital if theborrower were unable to obtain assistance fromusual sources. A participating member or non-member bank had to obligate itself for at least20 percent of’ any loss. The loans were for peri-ods up to five years (Board Annual Report 1934,50-51). Through 1939, the Reserve Banks hadapproved 2,800 applications and commitmentsamounting to $188 million at rates from 2.5 to 6percent (Smead 1941, 259). Although the Recon-struction Finance Corporation then assumed amore important role in providing working capi-tal for established businesses, the Reserve Bankscontinued to participate, approving an additional742 applications amounting to $382 millionthrough 1946 (Board Annual Report 1946, 10).

The aggregate amount of such loans was limit-ed by law to the surplus of the Reserve Banks

as of July 1, 1934, plus $139 million that theTreasury was to repay the Banks for their re-quired subscription to the Federal Deposit In-surance Corporation in an amount equal toone-half of their surplus on January 1, 1933.The required subscription was stipulated in theBanking Act of 1933 that created the FDIC(Board Annual Report 1933, 276-277). A commen-tator has noted that this “is the only instance inUnited States history in which Congress re-quired the central bank to expend its ownfunds to subscribe for more than a de minirnisamount of the capital of another unrelated en-terprise, other than obligations of the Treasuryitself” (Todd 1988, 130). In any event, theReserve Banks charged off the value of FDICstock on their books in the same calendar yearin which they paid for the subscription. Capitalloans to nonbanks under the authority of sec-tion 13(b), unlike the FDIC subscription, werevoluntary decisions of the Reserve Banks. Insection 2 below, I note a more recent attemptby the Treasury that was foiled to require theFed to expend its own funds in support of theFDIC.

Congressional authorization and FederalReserve implementation of loans to nonbanksfor use as capital was, in my judgment, a sorryreflection on both Congress’s and the Fed’s un-derstanding of the System’s essential monetarycontrol function. In 1946 the Federal ReserveBoard sought to eliminate its authority undersection 13W) to make loans directly to businessenterprises and replace it with a mandate re-stricted to guaranteeing such loans. A bill in-troduced in Congress early in 1947 on theBoard’s behalf would have authorized ReserveBanks to guarantee, up to a maximum of 90

percent, loans, extended by banks for as long as10 years to small- and medium-size business en-terprises, subject to a fee charge that increasedwith the guarantee percentage. The bill alsoprovided for the return of the amounts ad-vanced by the Treasury (up to $139 million) forthe Banks’ industrial loan operations, andpledged that no further Treasury appropriationsfor this purpose would be required (Board An-nual Report 1946, 8-10; 1947, 11-12).

Since the bill was not enacted, Reserve Banksfor the next decade continued to make and co-finance working capital industrial loans. Section13(b) was finally repealed by the Small BusinessInvestment Act of 1958, under the terms ofwhich the Reserve Banks restored to the ‘rrea-sury the amounts it had advanced under section

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62

13W) (Board Annual Report 1958, 95). ChairmanWilliam McChesney Martin, in testimony beforethe Subcommittee on Small Business of theSenate Banking and Currency Committee, whenit was considering this bill, stated well the Fed-eral Reserve’s considered judgment on its ven-ture into capital industrial loans: Its primaryobjective was “guiding monetary and credit poli-cy,” and “it is undesirable for the FederalReserve to provide the capital and participate inmanagement functions” of the proposed smallbusiness financing institutions (Federal ReserveBulletin 1957, 769).

I conclude this survey of Federal Reservelending activities since its founding by noting itssupport for solvency/capital lending programsunder wartime V-loan authority that it adoptedon April 6, 1942, and revised on September 26,1950 (Board Annual Report 1942, 89-91; 1950,72-74). Federal Reserve Banks were authorizedto act on behalf of the guaranteeing agencies(War Department, Navy Department, etc.) as fis-cal agents of the United States, meaning, theTreasury was required to reimburse them fortheir outlays. In acting as a guarantor of defenseproduction loans, the Federal Reserve provideda model of guaranteeing authority that waslater invoked when bailouts of peacetime enter-prises were proposed in the 1970s. Those de-velopments and Federal Reserve lending sincethe 1980s to institutions with a high probabilityof insolvency in the near term represent amajor departure from its historic mandate toprovide loans to illiquid but not insolventdepository institutions. In the section that fol-lows I discuss the apparent change in how theFederal Reserve regards its mandate.

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An appropriate starting point is the officialresponse to financial problems of the Penn Cen-tral Railroad that surfaced in 1970. Though itdid not lead to discount window assistance,nonetheless it reveals clearly the pressures thatwere to lead to such a practice. The Nixon Ad-ministration proposed to give the company a V-loan as a bailout. However, for the loan to be ofany use, legislative approval was required, sinceguarantees of loans for defense production were

to expire on June 30. When legislation stalled inCongress, the Administration requested the Fed-eral Reserve Board to authorize the FederalReserve Bank of New York to give the companydiscount window assistance. The request wasrejected and, as a result, the company filed forbankruptcy on June 21, 1970. On June 30, Con-gress approved a Joint Resolution, extending theDefense Production Act but limiting the maxi-mum obligation of any guaranteeing agency (forexample, the Federal Reserve) to $20 million,and stipulating that “The authority conferred bythis section shall not be used primarily to pre-vent the financial insolvency or bankruptcy ofany person, unless” the President certifies “adirect and substantially adverse effect upondefense production” (Federal Reserve Bulletin

1970, 720).

If the incident had ended at this point, itwould have been remembered primarily as apolitical dispute between the Administration andthe Congress. Penn Central’s bankruptcy wouldhave been regarded simply as the key to therestructuring of its operations. Instead, the Fed-eral Reserve reacted as though the company’sdefault on $82 million of commercial paper ithad outstanding would generate a financial cri-sis. The Federal Reserve assumed that lenderswould not discriminate between a troubled issuerand other perfectly sound issuers of commercialpaper, so that the latter would be unable to rollover their issues. “It was made clear that theFederal Reserve discount window would beavailable to assist banks in meeting the needs ofbusinesses unable to roll over maturing com-mercial paper” (Board Annual Report 1970, 18).

However, commer’cial paper issuers that faceddifficulties did so not because of the conditionof the market as such, but because of condi-tions peculiar to themselves (for example, Chrys-ler Financial and Commercial Credit) (Carron1982, 398). The fully justified verdict of the1971 Economic Report of the President (69) wasthat no “genuine liquidity crisis existed inmid-1970.”

The Penn Central episode fostered the viewthat bankruptcy proceedings by a large firmcreated a financial crisis, and that, if possible,bankruptcy should be prevented by loans andloan guarantees: the “too big to fail” doctrine inembryo.

The financial difficulties faced by New YorkCity in 1975 led the Federal Reserve to inform

Congress of its response to suggestions that itmight serve as a source of emergency credit.Governor George W. Mitchell cautioned “againstany proposals that would provide direct accessto central bank credit by hard-pressed govern-mental units” (Federal Reserve Bulletin 1975, 410).Chairman Arthur F. Burns reiterated that cautionand reported on contingency plans to increasetemporary discount window lending to commer-cial banks in the event of a major municipaldefault. However, he added that if a default ulti-mately required “write-downs that could seri-ously impair the capital of some banks,” theFederal Deposit Insurance Corporation, not theFederal Reserve, had statutory powers to assistfederally insured banks that found their capitalimpaired (Federal Reserve Bulletin 1975, 635-636).

In the end, Congress passed a law guaranteeingNew York City loans of up to $2.3 billion in1975, reduced to $1.65 billion in 1978, but theFederal Reserve’s involvement in the rescue ar-rangement was only limited fiscal agency serv-ices.3 The Fed also acted as fiscal agent forTreasury loan guarantees issued during thebailouts of the Lockheed (1971) and Chrysler(1979) corporations.4

I have been unable to find any reference tothe Fed’s involvement in these three loan guaran-tees in any of its publications. By consulting theU.S. Code—a source for lawyers, not econo-mists—however, I have been able to ferret outthe details of that involvement. My guess is thatthe Fed was unwilling to publicize its role be-cause it was not voluntary.

The most recent attempt to use the discountwindow to assist a nonbank involved the FDIC.In March 1991, the FDIC chairman, WilliamSeidman, requested Congressional authorizationfor a direct loan of $25 billion by the FederalReserve to the Bank Insurance Fund. ChairmanAlan Greenspan, testifying before the SenateBanking Committee the next month, opposedsuch a loan. That did not deter Treasury UnderSecretary for Domestic Finance Robert Glauberfrom renewing the request in testimony on May29, 1991, before a subcommittee of the HouseWays and Means Committee. The FederalReserve’s required subscription to the FDIC onits establishment in his view served as a prece-dent. The FDIC recapitalization and banking re-form bill that the Treasury prepared included

provisions authorizing the FDIC to borrow $25billion from the Federal Reserve Banks andamending section 13 of the Federal Reserve Act,authorizing any Federal Reserve Bank “to makeadvances to the Federal Deposit Insurance Cor-poration, upon its request” (Treasury bill 1991,sec. 402, 245). The July 23, 1991, bill preparedby the House Committee on Banking, Financeand Urban Affairs did not include those provi-sions (H.R.6, 102nd Cong., 1st sess.). The finallegislation, the FDIC Improvement Act of 1991,follows the House bill in increasing from $5 bil-lion to $30 billion the FDIC’s authority to bor-row directly from the Treasury, not from theFed.

Despite the restraint in the Act with respectto recapitalizing the FDJC, restraint is absentfrom another provision. The Act amended Sec-tion 13 of the Federal Reserve Act that dealswith the Federal Reserve’s authority to discountfor nonbanks. The amendment eliminated therequirement that the notes, drafts or bills ten-dered by nonbanks be eligible for discount bymember banks. As interpreted by Sullivan &Cromwell, a New York law firm, for its clientsin a memorandum of December 2, 1991, thisprovision enables the Fed to lend directly tosecurity firms in emergency situations. Tradi-tionally, commercial banks, knowing they hadaccess to the discount window, have lent tobrokerage firms and others short of cash in astock market crash. It is not clear why thetraditional practice was deemed unsatisfactory.In my view, the provision in the FDIC Improve-ment Act of 1991 portends expanded misuse ofthe discount window.

To this date, the Fed has apparently been areluctant participant in loans and loan guaran-tees to nonbanks. The question must be askedwhether it will be firm in the future in resistingpressures to fund insolvent firms that are politi-cally well-connected.

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S’-JlnlagJ Banks

In 1974 the Federal Reserve behaved contraryto traditional principles when uninsured deposi-tors started a run on the Franklin National Bankafter news surfaced that it had large foreign ex-change losses.The Comptroller of the Currencydid not close it promptly. The decision of the

4See U.S. Code (1971) for Lockheed and U.S. Code (1980)for Chrysler.

3See U.S. Code (1975, 1978).

regulators was that the Federal Reserve discountwindow, starting in May, would provide loansuntil the FDIC found a purchaser of the failedinstitution. Over the next five months, the Fed-eral Reserve Bank of New York lent continuous-ly to Franklin; the maximum amount lent, onOctober 7, 1974, was $1.75 billion, representingnearly one-half of Franklin’s assets. On October8, the hank was declared insolvent and takenover by a foreign consortium.

Among the precedents established by discountwindow lending to Franklin National was thatits London branch assets were accepted as col-lateral, and that, for the first time, the borrow-ings covered withdrawals from the Londonbranch as well as Franklin’s domestic branches.Although, on one hand, Fr’anklin National simplyborrowed at the discount rate, what was un-usual in this episode was that in September1974 the Federal Reserve assumed responsibilityto execute Franklin’s existing foreign exchangecontracts, since bidders for the bank were un-willing to honor them. it also agreed to extenddiscount window assistance, if needed, to thepurchasing bank. The FDIC, moreover, did notimmediately repay the discount window loan—its normal practice—but signed a three-yearnote obligating itself to do so as the collateralFranklin supplied was liquidated. In effect, theFederal Reserve lent capital funds that the in-surance agency contributed to the purchasingbank. The interest cost to the F’ed of subsidizingloans to Franklin has been estimated at $20 mil-lion (Garcia and Plautz 1988, 228). In executingFranklin’s foreign exchange contracts, the Fedalso incurred opportunity costs of staff time andlost interest on part of its portfolio.

The rescue of Franklin National Bank shifteddiscount window use from short-term liquidityassistance to long-term support of an insolventinstitution pending final resolution of its prob-lems. The bank was insolvent when its borrow-ing began and insolvent when its borrowingended. ‘rhe loans merely replaced funds thatdepositors withdrew, the inflow from theReserve Bank matching withdrawals.

The undeclared insolvency of Continental Il-linois in 1984 was also papered over by exten-sive discount window lending from May 1984 toFebruary 1985, albeit with smaller subsidiesthan in the case of Franklin National—an amend-ment to Regulation A as of September 25, 1974,permitted application of a special rate on emer-gency credit after eight weeks that was closer

to a market rate. The borrowing covering Con-tinental’s holding company as well as the bankat some dates amounted to as much as $8 billion.Again the FDIC assumed the bank’s loan, whichit eventually repaid from the proceeds of liq-uidating the bank’s assets, concluding with onelarge $2.1 billion payment in September 1989—an enormous cash drain.

The discount window has been valued by theFederal Reserve as a mechanism for directingfunds to an individual bank with liquidityproblems. It regarded its loans to Franklin Na-tional and Continental Illinois as exceptional oc-currences. However, when hundreds of CAMEL4- and 5-rated banks, as noted at the beginningof this paper, were receiving extended accom-modation even though they faced a high proba-bility of near-term failure, discounting can nolonger be regarded simply as a means of provid-ing temporary liquidity. What explains thistransformation in practice?

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in the United States, with federal spendingbudgeted at an all-time high, policy makers seethe discount window as a mechanism forproviding funds off budget. Legislation is neces-sary to authorize the Fed to provide assistanceto favored nonbanks, so the use of the windowisn’t kept secret, but it may seem a cost-freeway of funding them because repayment can berolled forward indefinitely. ‘rhis may explainthe recent spate of efforts to use discount win-dow assistance for nonbanks.

With respect to loans to banks with a highprobability of insolvency in the near term, it isnoteworthy that in 1974 only four banks failed.By the late I 980s, failures were numbered intriple digits, and the FDJC’s problem banks, infour digits. Having once set the precedent oflending to such problem institutions, at leasttwo explanations may account fox- this practiceby the Federal Reserve: (1) As in the case ofFranklin and Continental Illinois Banks, its ac-tions may have been taken at the bidding of theFDIC, or perhaps on its own initiative, in orderto mitigate the FDIC’s plight. (2) The FederalReserve may regard failure of a large institutionas potentially triggering a financial collapse or arun on the dollar. Fear of contagion may havebecome the Federal Reserve’s overridingconcern.

Even if these explanations account for thechange in Federal Reserve discount windowpractice, neither may justify the change. Beforedealing with this issue, it is important to assessthe costs of wholesale discount window lendingto insolvent institutions, to which I now turn.

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For the Fed to lend directly to the Treasuryor to government agencies that the Treasurywould otherwise fund through regular ap-propriations is a slippery slope. The costs arepoliticization of the money supply process. TheFed’s charter wisely prohibits such lending.

Discount window accommodation to insolventinstitutions, whether banks or nonbanks, misal-locates resources. Political decisions substitutefor market decisions. Institutions that havefailed the market test of viability should not besupported by the Fed’s money issues.

A depository institution traditionally was saidto be eligible for discount window assistancewhen it was illiquid but solvent. In recentyears, it has been given assistance when it wasliquid but its insolvency was undeclared. On amarket value basis, an institution is insolventwhen assets are less than liabilities. Since bookvalues are the usual measure of assets and lia-bilities, the divergence between assets and liabil-ities may only be revealed long after the marketvalue of its assets has fallen below the marketvalue of its liabilities. In addition, an institutionmay be liquid but insolvent, so long as its cashflow is positive.

A decision to declare an institution insolvent isthe prerogative of the chartering agency: theComptroller of the Currency for national banks,state authorities for state-chartered banks su-pervised by the Fed and the FDIC. The FDIC,since 1989, however, can both remove depositinsurance and substitute itself as receiver ofstate banks. It can force a state to close banksand, as the thrift insurer, close insolvent in-sured thrifts. (It does not have authority toclose credit unions.) If the chartering agencyhas delayed closure, the Federal Reserve hasacted as if a troubled institution is entitled todiscount window assistance provided it can fur-

nish acceptable collateral. The question I raise iswhether the Federal Reserve’s position is defen-sible when inferior CAMEL ratings provide in-dependent evidence on the likelihood of insol-vency in the near or immediate future.

Since the Federal Reserve routinely sterilizesdiscount window reserve infusions, does itmake any difference whether the reserves areprovided to solvent or insolvent banks orwhether the period for which the reserves areprovided is limited or extended? After all, if thereserves were not made available through thediscount window, open market purchases wouldadd an equivalent reserve contribution to thebanking system.

I believe that it does make a differencewhether reserves are injected by open marketpurchases or by discount window lending, espe-cially if insolvent banks are permitted to bor-row for extended periods. Discount windowlending may not affect proposed monetarygrowth, but it has other effects that make it anundesirable source of reserves.

Open market operations are anonymous. Themarket allocates reserve injections or withdraw-als among participants according to their xela-tive size and current opportunities. Muchgreater discretion is exercised by the FederalReserve in the allocation of reserves throughdiscounting, since the Fed knows the institu-tions that request discount accommodation. Thepublic learns about the magnitude of both openmarket operations and discount window creditfrom the data the Federal Reserve publishes,hut it does not learn the names of the banksthat received loans. The data made available tothe House Banking Committee in 1991 revealedthe names of the institutions that had faileddespite extended discount window loans, butnot the names of the few banks that hadreceived such loans but had not failed.~Thesecrecy may be good public policy, but it leavesopen the question whether provision of loanson a case-by-case basis assures equal treatmentfor all. This is an argument against discountwindow lending in general, not specifically toinsolvent banks, an argument that has oftenbeen made in the past without reference to thespecific problem of insolvent banks (for exam-ple, Friedman 1960, 38).

~ltwas only extended credit borrowers that failed in the datathe House Banking Committee obtained from the Fed in1991. Banks that obtained seasonal credit at the win-

dow did not fail. As footnote 2 on page 59 contends, thediscount window is not essential for this use.

Since the 1970s, the Federal Reserve has ex-tended long-term discount window assistance todepository institutions that by objective stan-dards were likely to fail. It has done so in thebelief that, in the absence of such assistance,contagious effects would spread from the trou-bled institutions to sound ones. The belief isparticularly entrenched for large troubled inter-mediaries, reflecting an apprehension that halt-ing the operation of such institutions wouldhave dire unsettling effects on financial mar-kets. Before 1985, the goal of such discountwindow assistance was a restructuring of theproblem institution as a viable entity with bothinsured and uninsured deposits made whole.

That was the situation in 1984 when Con-tinental Illinois was rescued. The implicationwas that any other response would havebrought on contagion. Yet if the bank had beenclosed before its net worth turned negative, theinstitutional depositors, foreign bank depositor-sand creditors who ran on it might well haveredeposited their withdrawals elsewhere orbought financial assets to replace the certificatesof deposit Continental issued and that theywere no longer willing to buy. Even if some in-terbank depositors that held as much as halftheir equity in uninsured deposits at Continentalhad obtained only a fraction of their claims im-mediately upon the closing, they would ulti-mately have recovered the full nominal value oftheir claims after liquidation of the bank.~Themarket would have known that the claimantson Continental were not in jeopardy. Even ifclosing Continental had led to runs on the for-eign interbank depositors — ostensibly the rea-son for keeping Continental in operation — thelenders of last resort in the nations concernedcould have provided adequate liquidity in theirmarkets to tide the banks over if the Continen-tal deposits were their only problem. Fear ofcontagion should not determine a regulator’s de-cision to keep an insolvent bank open. It shouldlead the Fed to lend to the market to preventthe contagion.

If fear of contagion is a lesson the FederalReserve has learned from the banking panics of1930-33, it is the wrong lesson. Contagion thenoccurred in an environment in which the Fed

permitted the money supply to decline drastical-ly, rendering banks insolvent not because oftheir own actions but simply because of the col-lapsing economy. The right lesson is that con-tagion need not arise if open market purchasesare made adequate both to reassure the marketand to prevent a collapse in the quantity ofmoney. Examples are the Fed’s provision of li-quidity to cushion the economy from the effectsof the 1987 stock market crash and the collapseof Drexel Burnham.

Since 1985, prolonged discount window as-sistance has generally terminated not with re-structuring but with closure of the insolventbanks. When banks are known to be insolvent,postponement of recognition of losses that haveoccurred might well have increased currentlosses. Uninsured depositors have more time towithdraw their funds. The insurance agency,which is to say the taxpayer, ultimately bearsany added costs of delayed closure. By lendingto the banks in question, the Federal Reserveencourages this practice. Absent regulatory re-straints or incentives to the contrary, the policyclearly encourages risk-taking and invites moralhazard problems. If a bank with the leastdesirable CAMEL rating can obtain subsidizeddiscount window assistance, that institution ob-tains a competitive advantage over solvent onesfor as long as the Federal Reserve supports it.~

The Federal Reserve Banks decide whetherthey will extend a loan on the basis of collateralthat the would-be borrowers offer. This deci-sion is undoubtedly influenced by the conditionof the insurance agency: whether it has thefunds to pay off depositors and take over thefailing bank’s assets when it cannot arrange amerger of an insolvent bank with a solvent oneor arrange removal of existing management byplacing an institution in receivership. The condi-tion of the insurance agency in turn is also af-fected by a chartering agency’s forbearance orprompt action in declaring the insolvency ofone of its constituents. The Federal Reserve hascooperated by extending long-term support toan institution with a high probability of failureuntil a resolution of its problems was arrived at.

Discount window lending to insolvent banksmight cease if, under the terms of the FDIC lm-

GThis assumes that the bank’s value would have been real- compared to what deposit brokers and other non-Fedized in a forced sale of assets. sources of funds would charge if the dying banks were left

‘The subsidized rate may have risen to take into account to fend for themselves in the market.rates on market sources of funds but it is still a subsidy

67

provement Act of 1991, the Fed no longer ad-vanced funds to keep critically undercapitalizedinstitutions in operation, and the insuranceagency took prompt corrective action to appointa receiver for those institutions.~

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(7(3j751 •iJ)1fl~%7’9

Would discontinuation of Fed lending to insol-vent banks establish the inviolability of the dis-count window? For many reasons that is notthe case.

Regardless of one’s attitude to discount win-dow lending for seasonal and adjustmentpurposes—the private sector could accommodatethose needs—many economists customarily as-sign one indispensable function to the discountwindow, namely, as lender of last resort: TheFederal Reserve should use discounting in “ex-ceptional circumstances” (in the words of Regu-lation A) to provide extended credit to solventinstitutions with liquidity problems.

However, the Federal Reserve does not needthe window to serve as a lender of last resort.The case against operation of the discount win-dow has rested on grounds that open marketoperations are sufficient for the execution ofmonetary policy in both ordinary and exception-al circumstances, that individual banks thatneed and can justify special assistance canreceive such assistance through the federalfunds market, and that discounting invites dis-cretionary subsidies to banks favored by theFed (Goodfriend and King 1988, 216-53).

There is still another reason that the discountwindow serves no useful purpose. A review ofthe use of the discount mechanism by the Fed-eral Reserve since its founding demonstrates aseries of misconceptions on its part about whatit can achieve by affording banks the opportuni-ty to acquire borrowed reserves. The miscon-ceptions have varied over time, depending onthe objectives the System pursued.

Let me note some of the misconceptions:

(1) The Federal Reserve can determine whetherborrowed reserves serve “productive” ratherthan “speculative” use of credit.

(2) Banks borrow only for “need” and not forprofit.

(3) The absolute level of free reserves or bor-rowings indicates whether banks choose toacquire or liquidate assets.

(4) The spread between discount rates and mar-ket rates does not affect bank borrowing.

(5) The tradition against continuous borrowingis a satisfactory substitute for a penalty dis-count rate.

(6) Borrowing by banks signals bank weakness.

(7) Little bank borrowing signifies money mar-ket ease.

(8) “Technical” adjustments may explain discountrate changes, but their announcement con-veys useful information to financial markets.

(9) Banks can be dissuaded from excessive useof the discount window by Reserve Bank ap-peals and exhortations instead of discountrate increases.

Since the 1970s, the Federal Reserve has actedon the belief that discount window assistance tobanks with a high probability of insolvency inthe near term, especially large ones, will, bydelaying closure, eliminate contagious effects onfinancial markets.

In practice, the Federal Reserve’s discountwindow activities have created perverse incen-tives, shifting risk from depositors to taxpayers.If a threat of systemic bank failures did arise,the Fed should counter it by open market oper-ations, rather than by assistance to individualinstitutions. However, if the Federal Reserveprevents serious declines in the money supply,it is highly unlikely that the failure of an in-dividual bank, however large, would trigger sys-temic bank failures.

Closing the discount window would ft-ce theFed not only from likely future misconceptionsbut also from the recurrent pressures, to whichit has been subject since the New Deal, to ac-commodate nonbanks, not to mention pressuresfrom the Treasury to fund government agenciesoff budget.

5, (.TONC.11l..1ILJIN IT? (i.I’17.1111581’S

I’ve surveyed the changes in Federal Reservediscount window practices since the System’sfounding. Early on the System emphasized that

8For an alternative view of the possible consequences of aprompt corrective action strategy, see A. Alton Gilbert(1991).

borrowing was supposed to he limited to short- effects of its actions. These mistakes haveterm reserve needs. By the I 980s, hundreds ofbanks rated by regulators as having a highprobability of failure in the near term andwhich ultimately failed were receiving extendedaccommodation at the discount window.

My reading of this recent experience is thatthe change in discount window practices, bydelaying closure of failed institutions, increasedthe losses the FDJC and ultimately taxpayersbore.~Recent legislation limits use of the dis-count window for long-term loans to troubledbanks. More important, it also provides that asupervisory agency is to appoint a receiver foran institution that falls below a critical capitalratio, curtailing the regulator’s discretionregarding when to intervene in the case of anundercapitalized bank.

These changes, even if implemented—it is notyet known whether they will be—do not sanctifythe continued operation of the discount window.Individual banks that need assistance, if credit-worthy, can obtain loans without subsidies fromthe federal funds market. The Fed can be an ef-fective lender of last resort if restricted to openmarket operations. In administering the discountwindow, the Fed has been prone to mistake the

marred its execution of monetary policy.

Without a discount window, the Fed willavoid pressures to lend off budget to nonbanksand to government agencies, which should befunded thi-ough regulax appropriations. Withoutthe distraction of monitoring collateral anddeciding which bank applicants qualified forassistance, it can concentrate its energies onopen market operations, the single instrument itneeds to control the quantity of money. Withouta discount window, there will he no announce-ment effects since the Fed will not have to setthe discount rate. That should dispel the im-pression that it controls market interest rates.

A Federal Reserve System without the discountwindow would he a better functioning institution.

Board of Governors of the Federal Reserve System. AnnualReport (Washington, D.C., selected years).

Economic Report of the President (Washington, D.C., 1971).Federal Deposit Insurance Corporation Improvement Act of

1991.Federal Reserve Bulletin (Washington, D.C., selected years

and months).

9My conclusion from reading the 1991 Senate and Househearings on the long-delayed closings of the Bank of NewEngland and Madison National Bank is that delay in-creased resolution costs. The condition of the institutionsdeteriorated as the Fed continued to lend to them — theywere already rated CAMEL 5 when the continuous loansbegan. With the value of liabilities greater than of earningassets in these institutions, the gap grew as interest in-curred on liabilities exceeded earnings on assets.

Delay, moreover, allowed outflows of uninsured deposits.Had the institutions been closed promptly, the earningsdeficiency could have been offset at least somewhat byreducing the principal paid to uninsured depositors. Evenso, at the closing, Bank of New England held $2.3 billionin uninsured deposits, of which $1.25 billion were brokered.At their peak, Fed advances amounted to $2.26 billion, TheFDIC’s loss was $2.5 billion. As L. William Seidman testi-fied, the FDIC decided to protect all depositors of the Bankof New England, at “the additional cost lofl somewhere inthe $200 to $300 million range up front” (see his statementin Senate Hearings on the failure of the Bank of New En-gland, pp. 25-26).

In the absence of Fed lending to a bankrupt institution,early closing would have prevented a flight of uninsureddeposits. In effect, Fed lending merely replaced withdraw-als of uninsured deposits. Before it was declared insolvent,the Fed had lent the Madison National Bank $125 million,which kept the bank open to permit withdrawals of $108million in uninsured deposits. The FDIC’s final loss was$156 million.

The FDIC suffers losses not only in cases in which it liq-uidates failed banks but also in cases in which it arrangessome form of purchase and assumption. When it liquidatesa failed bank, the FDIC pays depositors the face value oftheir claims and suffers a reduction in its reserves meas-

ured by the full difference between book and currentvalues of the assets that support the deposits. When it ar-ranges a purchase and assumption, it transfers thedeposits to the buyer and, depending on the purchaseprice it has accepted, the FDIC is responsible for the re-maining difference between book and current values of as-sets that support the deposits transferred.

In my opinion, delay in recognizing losses that alreadyexist cannot be justified by the claim that the FDIC usesthe time to improve the behavior of the bankrupt institu-tion, even if it were true that supervisors would be suc-cessful at this late date in the institution’s history inreforming it. Delay may, however, be helpful to the FDIC’spublic image by postponing a publicly disclosed decline inthe stated value of the reserves in the fund. That may bethe real reason the FDIC welcomes delay.

The FDIC has stated that the value of a bank to potentialbidders goes down when it is already involved in resolvinga failed bank case, as if that would validate delay. In fact,it is the difference between book and market value of abank’s assets which a potential bidder learns that accountsfor any decline in the bank’s value, not the fact that an ef-fort at resolution is under way.

What needs to be explained is why the Fed is the tenderand not the FDIC, which has had the authority since 1982to lend to open bankrupt banks and since 1989 to conser-vators. Some buyers might argue that assets are worthmore if FDIC can step in after it has fixed a price in a pur-chase and assumption transaction and abrogates contractsthe institution has with third parties, e.g., for rent, utilities,etc. That would be harder to do legally if the FDIC alreadycontrolled the bank or had an outstanding loan to it. Thatis not an argument that should encourage the Fed to lendinstead of the FDIC.

Friedman, Milton. A Program for Monetary Stability. The MillarLectures. Number Three (Fordham University Press, 1960).

Garcia, Gillian and Elizabeth Plautz. The Federal Reserve:Lender of Last Resort (Ballinger, 1988).

Gilbert, R. Alton. “Supervision of Undercapitalized Banks: IsThere a Case for Change?” this Review (MaylJune 1991),pp.16-30.

Goodfriend, Marvin and Robert G. King. “Financial Deregula-tion, Monetary Policy and Central Banking:’ in W.S. Harafand R.M. Kushmeider (eds.) Restructuring Banking & Finan-cial Services in America (American Enterprise Institute,1988).

Hackley, Howard. Lending Functions of the Federal ReserveBanks: A History (Board of Governors of the FederalReserve System, 1973).

Kaufman, George. “Lender of Last Resort: A Contempora~yPerspective[ Journal of Financial Services Research, Vol. 5(1991), pp. 95-110.

Shull, Bernard. “Report on Research Undertaken in Connec-tion With a System Study:’ in Reappraisal of the FederalReserve Discount Mechanism, Vol. 1 (Board of Governorsof the Federal Reserve System, 1971), pp. 27-76.

Smead, Edward L. ‘Operations of the Reserve Banks,” inBanking Studies (Board of Governors of the FederalReserve System, 1941), pp. 249-70.

Todd, Walker F “Lessons of the Past and Prospects for theFuture in Lender of Last Resort Theory,” Federal ReserveBank of Cleveland Working Paper 8805 (1988).

U.S. Code. Emergency Loan Guarantee Act. 15 United StatesCode Sections 1841-1852. Public Law 92-70; 85 Stat.178-182 (August 9, 1971), pp. 193-98; Legislative History, pp.1270-78.

New York City Seasonal Financing Act of 1975.Formerly enacted (now omitted from Code) as 31 UnitedStates Code Sections 1501-1510. Public Law 94-143; 89Stat, 797 (Dec. 9, 1975), pp. 797-99; Legislative History, p.1509,

_______ New York City Loan Guarantee Act of August 8,1978. Formerly enacted as 31 United States Code Sections1521-1531; see note under 31 USC. Section 6702. PublicLaw No. 95-339.

Chrysler Corporation Loan Guarantee Act of 1979.15 United States Code Sections 1861-1875. Public Law96-185;85 Stat. 1324 (January 7, 1980), pp. 1324-37.

U.S. Rouse of Representatives, Committee on Banking,Finance and Urban Affairs, Staff. ‘An Analysis of FederalReserve Discount Window Loans to Failed Institutions”(Processed, 1991).

U.S. House of Representatives, Committee on Banking,Finance and Urban Affairs. A Bill to Reform the Deposit In-surance System ... and For Other Purposes (1991).

_______ Failure of Madison National Bank, Hearing, 102ndCong. 1st sess., Serial No. 102-38 (Government PrintingOffice, May 31, 1991).

_______- The Failure of the Bank of New England Corporationand Its Affiliate Banks, Hearing, 102nd Cong. 1st sess.,Serial No. 102-49 (Government Printing Office, June 13,1991).

U.S. Senate, Committee on Banking, Housing, and Urban Af-fairs. The Failure of the Bank of New England, Hearings,102nd Cong. 1st sess., Serial No. 102-354 (GovernmentPrinting Office, January 9, May 6, and September 19,1991).

U.S. Treasury Department, Capital Markets Legislation Office.“A Bill to Reform the Federal Deposit Insurance Systemand for Other Purposes: (Processed, 1991).

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