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Why Do Banks Feel Discount Window Stigma?
Posted By Guest Author On January 19, 2014 @ 5:00 am In Credit,Regulation,Think Tank | Comments Disabled
Why Do Banks Feel Discount Window Stigma?
Liberty Street Economics January 15, 2014
Even when banks face acute liquidity shortages, they often appear reluctant to borrow at the New York Fed’s discount window (DW) out of concern that such borrowing may be interpreted as a sign of financial weakness. This phenomenon is often called “DW stigma.” In this post, we explore possible reasons why banks may feel such stigma.
The problem of stigma has been a lingering issue throughout the history of the DW. Prior to 2003, banks in distress could borrow from the DW at a rate below the fed funds target rate. Because of the subsidized rate, the Fed was concerned about “opportunistic overborrowing” by banks. Accordingly, before accessing the DW, a bank had to satisfy the Fed that it had exhausted private sources of funding and that it had a genuine business need for the funds. Hence, if market participants learned that a bank had accessed the DW, then they could reasonably conclude that the bank had limited sources of funding. The old DW regime therefore created a legitimate perception of stigma.
To address such stigma concerns, the Fed fundamentally changed its DW policy in 2003. In Regulation A, as revised in 2003, the Fed classified DW loans into primary credit, secondary credit, and seasonal credit. Financially strong and well-capitalized banks can borrow under the primary credit program at a penalty rate above the target fed funds rate (rather than a subsidized rate, as in the past). Other banks can use the secondary credit program and pay a rate higher than the primary credit rate. Finally, seasonal credit is for relatively small banks with seasonal fluctuations in reserves. For banks eligible for primary credit, the new DW is a “no-questions-asked” facility. Namely, the Fed no longer establishes a bank’s possible sources and needs for funding to lend under the primary credit program. Instead, primary credit for overnight maturity is allocated with minimal administrative burden on the borrower. Hence, access to primary credit need not be motivated by pressing funding needs nor signal financial weakness. In other words, there’s no structural reason why stigma should be attached to the new DW.
Nevertheless, stigma concerns resurfaced in 2007 at the onset of the recent financial crisis. In fact, as adverse liquidity conditions in the interbank markets persisted at the end of 2007, the Fed had to put in place a temporary facility, the Term Auction Facility (TAF), which was specifically designed to eliminate any perception of stigma attached to borrowing from the DW. Further, as discussed in a previous post, there’s strong evidence that banks experienced DW stigma during the most recent financial crisis.
So why do banks still feel DW stigma? In a recent staff report , we explored different hypotheses related to factors that may exacerbate or attenuate DW stigma. To conduct our analysis, we compared the DW rate with the bids each bank submitted at the TAF between December 2007 and October 2008. As explained in our paper, it can be shown with a simple arbitrage argument that, absent DW stigma, a TAF bidder should never bid above the prevailing DW rate. We therefore interpreted a bank bidding above the DW rate as evidence of DW stigma. Then, we conducted an econometric analysis to identify a bank’s possible determinants of DW stigma. Among the various hypotheses we tested, we report here the most interesting.
In summary, our study provided a better understanding of the reasons why banks may feel DW stigma. In particular, we found that the incidence of DW stigma was higher for foreign banks, banks that could be identified more easily, and banks outside the New York Federal Reserve District, as well as after financial markets became stressed. In contrast, we found no evidence that DW stigma may be due to a lack of coordination among banks when accessing the DW.
The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.
Olivier Armantier  is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.
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URLs in this post:
 staff report: http://www.newyorkfed.org/research/staff_reports/sr483.html
 Image: http://libertystreeteconomics.typepad.com/.a/6a01348793456c970c019b00415b56970d-popup
 Olivier Armantier: http://www.newyorkfed.org/research/economists/armantier/index.html
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