Discount window

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What is it?

The discount window is a central bank's way of setting interest rates.

This is not to say that if you go and visit the US Federal Reserve or the Bank of England you will actually be able to see the discount window somewhere to the right of the main entrance - the discount window is a notional, rather than a physical, entity.

How does it work? Most financial institutions find themselves occasionally short of ready cash - for example, a retail bank with a lot of depositors may find that a higher-than-average percentage of them decide to withdraw money on one particular day.

When this happens, that bank will need to borrow cash on a short-term basis. It does this by treating the central bank a little like a pawnbroker: it will leave some of its finest assets there (historically, government bonds and the like) in return for ready money. At the same time, however, it will promise to buy those assets back in the future. And when it buys them back, it will have to pay the central bank a little bit more than the central bank paid out in cash when the assets were parked with it.

The percentage difference between these two amounts is the interest rate, as set by the Bank of England, the US Federal Reserve, the European Central Bank (ECB), or the central bank in whichever other jurisdiction the borrowing bank is operating.

What's it got to do with the financial crisis?

Under the credit crunch, the discount window has become an incredibly important means by which central banks can pump liquidity (ie, cash) back into the banking system.

For example, the ECB will now exchange cash for asset backed securities (ABS), which are virtually unsaleable elsewhere.

In the UK, the Bank of England initiated the Special Liquidity Scheme, under which it agreed to swap government securities (which can more easily be sold for cash) for AAA-rated asset backed securities, just as long as they were held on banks' balance sheets before the end of 2007. In September 2008, it said it would also accept AAA-rated mortgage backed securities in an effort to pump liquidity into the banking system.

In the US, the Federal Reserve has also taken action. After Bear Stearns went under, it extended the term of its loans to 90 days and (for the first time since the Great Depression) set up a 'primary dealer credit facility' (PDCF), allowing broker dealers working only with institutional clients to borrow from its discount window along with retail and commercial banks. The scope of the PDCF was broadened after Lehman Brothers went under and AIG nearly followed it down in September 2008: the Fed agreed to accept a broader range of collateral, including non-investment grade securities and equities, in exchange for loans from the facility.

When the US government's $700bn bailout plan stalled one week later, all major central banks globally began pumping money into the financial system via their discount windows. With banks suspicious about which one would go under next, little or no money was lent between financial institutions on the money market (banks' usual method of raising overnight cash). Central banks were therefore forced to keep the financial system afloat.

In August 2009 the Fed announced it had lowered the margin requirements for collateral that banks pledge to the discount window, making it easier for banks to borrow emergency cash.

Last updated on 7 September 2009.

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