By David Benoit 

Banks have all but abandoned the Federal Reserve's discount window, and it is straining Wall Street's postcrisis infrastructure.

Borrowing from the discount window, the Fed's only channel for lending directly to banks, has plummeted. Through October, banks are on pace to borrow just $750 million from the Fed this year, half of last year's total and well below the record low of $940 million set in 1961.

Banks are desperate to avoid the stigma attached to accessing the window, which is designed to help them weather short-term funding crunches. It is one reason they are hoarding cash at levels well above what regulators require, ensuring that they won't be caught short if markets go awry.

The hoarding has drained liquidity from other parts of the market, contributing to a cash shortfall that roiled overnight-lending markets in September. The resulting spike in rates forced the Fed to inject tens of billions of dollars into the market for repurchase agreements to stabilize it. Two months later, the Fed is still pumping money into the repo market.

The ripple effects of the malfunctioning discount window show how a thicket of postcrisis banking regulation has combined with a decade of Fed intervention to reshape the financial system's plumbing in ways even regulators and central bankers struggle to understand.

JPMorgan Chase & Co., for example, keeps about $120 billion in reserves at the Fed and won't let it dip below $60 billion on any given day, Chief Executive James Dimon said at a conference last month. Doing so gives the bank a big buffer over its regulatory requirements -- before the crisis, the bank's Fed balance would routinely slip into negative territory -- but it also deprives the market of $60 billion in daily liquidity.

"Remember, these were very healthy markets that had that repo issue," Mr. Dimon said. "In a tough market, that will be harder and more disruptive."

Deposit-holding banks can access the discount window for short-term, usually overnight, funding. The loans aren't meant to be used regularly; rather, they are designed to tide banks over during cash crunches. To discourage banks from relying too heavily on the window, the Fed charges a higher interest rate than they would typically pay for short-term funding.

Before the crisis, banks would occasionally turn to the window to cover unexpected funding gaps created when, for example, a wire transfer didn't arrive on schedule. The window helped stabilize banks and keep money flowing through the system after the Sept. 11, 2001, terrorist attacks and during the financial crisis. In 2008, when the financial system flirted with disaster, banks borrowed more than $1.2 trillion from the discount window.

Truly distressed banks can't access the window; borrowers have to be solvent and post collateral for the loans. But banks have long feared that a visit to the discount window could raise doubts about their liquidity and stability, which could spur a run on even a healthy institution.

While banks largely have been flush with cash in recent years and haven't especially needed the discount window, the stigma attached to it has only worsened.

The Dodd-Frank financial overhaul enacted in the aftermath of the crisis required the names of the banks that borrowed from the discount window to be disclosed on a two-year lag. Bankers who used to tap the window say the required disclosures are the biggest reason they won't do so anymore.

Bank executives are also worried that borrowing money from the Fed, even on a short-term basis, could look to the public like one of the widely criticized bailouts of the crisis.

In an August survey, the Fed asked senior bank officials about the likelihood for their respective institutions using the discount window. "Very unlikely" was the unanimous answer.

To some extent, their reaction is by design. Regulators have pushed banks to bulk up on capital so they won't need the government again. In their living wills -- the plans banks must file laying out how they will handle severe stress or collapse -- banks can't rely on the discount window to stay afloat. But banks are keeping far more cash in reserve than regulators require.

"They are managing their liquidity to bring to zero the odds they ever have to go to the discount window," said Bill Nelson, chief economist at the Bank Policy Institute who helped rewrite the discount window rules in 2003 when he worked at the Fed.

In September, a sudden cash shortfall in the repo market sent the rate for the overnight loans to 10% from just over 2%. The shock caught the Fed by surprise.

Bankers and regulators have blamed the spike on a shortage of banking reserves available for borrowing when large payments of corporate taxes and a sale of Treasurys drained cash from financial institutions. Banks hit the limits on what they consider to be safe levels of reserves and stopped lending to the repo markets, sending rates higher. If banks considered the discount window as an acceptable source of funding, they may have been willing to part with more of their excess reserves.

What's more, the rate surge was the kind of stress the discount window is designed to ease. Yet Fed data indicate no significant borrowing happened during the September chaos.

The Fed continues to pump money into the repo market on an ad hoc basis. It also has discussed making the injections more permanent to give banks a palatable alternative to the discount window, hoping to spur them to free up some reserves.

Some bankers aren't convinced it would work. Borrowing from the Fed, even without an interest-rate penalty, conjures too many memories of the crisis.

"The discount window is option E," said the treasurer of a big U.S. bank. "This would be maybe option D."

Write to David Benoit at david.benoit@wsj.com

 

(END) Dow Jones Newswires

November 21, 2019 07:14 ET (12:14 GMT)

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