Discounting, Rediscounting and Discount Window Loans

The interest rate Federal Reserve banks charge on loans to banks in

their district is called the discount rate. The facility, or division, through

which these loans are provided is called the discount window, and the

loans are called discount window loans. The least mysterious of these

terms is the window, referring to the actual window where at one time

Fed tellers made loans to banks. But why the term discount? What is dis-

counted? Today, nothing is discounted; discount loans are merely loans

of reserve funds to banks in need of reserves.

The Federal Reserve Act of 1913, which created the Federal Reserve

System, provided for the Fed to make loans to banks. Actually, the act

provided for ‘rediscounting commercial paper.’ All of these terms have

their origins in the early history of central bank practices, especially in

Europe and Japan, on which the Fed’s practices were patterned.

To understand discounting and rediscounting, let us imagine our-

selves back at the early years of the Fed’s life. (This also permits us to use

the present rather than the past tense.) Imagine a retailer in Raincity,

Washington, who places an order with a manufacturer in New York for

100 umbrellas to be delivered in three months, in time for the coming

rainy season. He signs and gives to the manufacturer an IOU, or ‘bill

of exchange,’ of $1,000, which promises payment of that amount at the

time of delivery. The New York manufacturer, however, wants to be paid

at once. He takes the bill to his bank, NY Bank, which ‘discounts’ the

paper. That is, NY Bank pays the manufacturer the present value of the

three-month $1,000 bill, which, of course, is less than $1.000; hence,

the term discounting. The two parties agree that in calculating the present

value NY Bank uses the current three-month interest rate. The bank now

has in its portfolio the bill signed by the Raincity retailer. In effect, NY Bank

has made a three-month loan to the retailer at the market interest rate.

Next, suppose that on the same day NY Bank realizes that it needs

more liquidity and decides to sell this IOU by endorsing it to another

bank, Streetbank. The buying bank discounts it, that is, pays the present

value of the $1,000 face value. Of course, if Streetbank uses the same

interest rate in the calculation, the selling price would be exactly what

NY Bank paid the manufacturer. NY Bank can also sell the paper at the

discount window of its banker, the New York Fed. In this case, the New

York Fed ‘rediscounts’ the paper. If the discount window officer uses

today’s three-month market interest rate to calculate the paper’s present

value, NY Bank will be paid the same price that it would have received

from Streetbank. The Fed would merely provide NY Bank liquidity. This

service would be especially valuable to banks in areas with limited access

to financial markets.

If the discount window officer calculates the present value using a

discount rate lower than the market interest rate, the price that NY Bank

receives will be higher. In this case, the Fed’s service to the bank is more

than merely providing liquidity. It is a source of profit for the bank. The

difference between the price the bank paid to acquire the IOU and the

price it receives at the discount window is a result of the difference be-

tween the interest rate on the paper and the discount rate the Fed used.

In effect, NY Bank borrows from the Fed at a lower rate (the discount

rate) than the rate it charges the retailer.

Central banks, including the Fed, learned early on that by changing

the discount rate, they could affect the profitability of borrowing from

the Fed and thus affect the amount of credit in the economy. Until the

1930s, discount rate policy was the principal, if not the only, instrument

of monetary policy.

In modern times, the Fed does not make loans to banks by redis-

counting paper in their possession. The Fed simply makes outright loans,

called advances. Perhaps to underscore the history of discounting or to

keep up appearances, the Fed normally requires borrowing banks to post

supporting collateral paper, even though ‘borrowers in good financial

condition who seek short-term adjustment credit may be permitted to

hold their own collateral appropriately earmarked.’

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