WASHINGTON, May 18: The US Federal Reserve on Friday proposed making it easier for banks to obtain loans from the central bank, in an effort to reduce volatility in the interest rate it uses for monetary policy.
The Fed stressed that the proposed changes, which would raise the cost of direct loans from the central bank even while lowering other hurdles, would not have an impact on its monetary policy stance.
This does not involve a change in the stance of monetary policy. It is a technical change, Fed Governor Edward Gramlich told reporters on a teleconference.
The move, if adopted after a 90-day public comment period, would make it easier for banks to borrow from the Fed by scrapping a requirement that they first exhaust other reasonably available sources.
But the plan would encourage banks to first look for funds on the open market, by initially placing the interest rate for direct short-term loans from the Fed’s so-called discount window 1 percentage point above the target the central bank sets for overnight lending between banks.
We feel the discount window should contain an incentive for banks who want funding ... to go to private markets for funds first, Gramlich said.
Historically, the US central bank has kept the discount rate below its target for the overnight bank rate — known as the federal funds rate — which is the Fed’s chief monetary policy tool. Currently, the federal funds rate target is at a 40-year low of 1.75 per cent and the discount rate is 1.25 per cent.
While the new rate on direct short-term loans from the Fed — dubbed the primary rate — would initially be set 1 percentage point higher than the federal funds rate, afterward it would be set by the Fed board in the same procedures currently used in setting the discount rate.
A secondary rate — to be set initially at 1.5 percentage points over the federal funds rate — would replace the Fed’s current program for longer-term loans and would be used for less-sound banks that fail to qualify for the primary rate.
Gramlich said under the proposal banks borrowing from the Fed could loan the funds back into the market, which would further help to reduce volatility because it would make more funds available even for those banks that might not qualify for the direct loans.
Apart from reducing volatility and making it easier for banks to borrow from the central bank, Gramlich said the proposal, while not a response to the Sept. 11, attacks, could prove useful during a financial crisis.
In addition, the Fed said the changes would help reduce administrative costs at the central bank. Because banks will no longer need to prove they tried to borrow elsewhere without success, the plan will reduce time-consuming paperwork, a Fed spokesman said.
The Fed is trying to streamline the process so they don’t have to go about evaluating borrowers, as to whether or not they have used all other sources of liquidity, said Keith Leggett, senior economist at the American Bankers Association.
He also said it eliminates the possibility that a bank could borrow at a below-market rate just to lend the funds at a higher rate and pocket the difference.
In a May 1998 survey, the Fed asked bank senior loan officers about such a restructuring of discount window lending. About three-quarters of the respondents indicated they would be willing to borrow from it on any day the fed funds rate moved above the Lombard rate.
At a board meeting later that year, Gramlich raised the question of whether the Fed should move to such a system.
Gramlich brought up the idea again at a meeting in July 1999. At that meeting, Fed Chairman Alan Greenspan said the proposal needed to be evaluated further.
The last time the Fed made changes to the discount lending window was a precaution against potential Y2K problems with the arrival of the year 2000.
Before that, the last changes were in the early 1980s when the window was first opened to all depositing institutions, not just commercial banks.—Reuters