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Federal Reserve Bank of Philadelphia


Federal Reserve Bank o f Philadelphia
Ten Independence Mall
Philadelphia, Pennsylvania 19106



Herb Taylor

Brian C Gendreau

The role o f the discount window in the Fed’s
money control strategy is a topic o f continuous
debate. Recommendations for interest rates at
the window run the gamut from a penalty rate to
a subsidy rate. Now that the Fed is using open
market operations to target reserves, and is
instituting new reserve accounting procedures,
how should the discount rate be set to improve
the Fed’s control over the money stock? The
answer depends on how well the Fed is able to
predict the public’s demand for money and the
financial system’s willingness and ability to
supply it.

Large banks are making many loans at belowprime rates. At the same time, banks are changing
the prime faster in response to market interest
rate movements. Both these changes can be
traced to shifts in the sources o f banks’ lendable funds. As interest rates became more
volatile in recent years, banks were forced to
rely increasingly on liabilities paying market
rates o f interest, and to charge rates on loans
that were closer to rates on money market in­

The BUSINESS REVIEW is published by the
Department o f Research every other month. It is
edited by Judith Farnbach. Artwork is directed by
Ronald B. Williams, with the assistance o f Dianne
Hallowell. The Review is available without charge.
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sent to the Department o f Public Services.

The Federal Reserve Bank o f Philadelphia is part
o f the Federal Reserve System— a System which

includes twelve regional banks located around the
nation as well as the Board o f Governors in Wash­
ington. The Federal Reserve System was established
by Congress in 1913 primarily to manage the nation’s
monetary affairs. Supporting functions include
clearing checks, providing coin and currency to
the banking system, acting as banker for the Federal
government, supervising commercial banks, and
enforcing consumer credit protection laws. In
keeping with the Federal Reserve Act, the System is
an agency o f the Congress, independent adminis­
tratively o f the Executive Branch, and insulated
from partisan political pressures. The Federal
Reserve is self-supporting and regularly makes
payments to the United States Treasury from its
operating surpluses.

The Discount Window
and Money Control
by Herb Taylor 9
Concerned about the inflationary pressures that
rapid money growth can create, the Federal Reserve
has been moving to improve its control over the
nation’s money stock in recent years. In October
1979, the Fed began using its open market oper­
ations to control more closely the supply o f bank
reserves— the raw material banks need to create
money. Recently, the Fed’s Board o f Governors
voted to adopt a system o f contemporaneous
reserve requirements that will strengthen the link
between reserves and money. The new system o f
reserve requirement accounting is scheduled for
implementation early in 1984, and once in place,
two o f the Fed’ s major policy tools— open market
operations and reserve requirements— will have
been reworked to produce better money control. Is
an overhaul o f the Fed’s third policy tool— the

‘ Economist in the Banking Section o f the Research Depart­
ment o f the Federal Reserve Bank o f Philadelphia.

discount window— the next logical step? Perhaps
In addition to supplying reserves to the financial
system through open market operations, the Fed
also lends reserves to banks at its discount window.
The Fed generally has set the discount rate, the
interest rate on borrowed reserves, somewhat
below short-term market interest rates, and has
relied on an established set o f lending practices to
limit the amount banks borrow at the discount
Before the Fed’s October 1979 switch to a
reserve-oriented procedure for open market oper­
ations, its handling o f the discount window had
little impact on the Fed’s ability to control the
money stock. Now, with the Fed following the
reserve operating procedure, but contemporan­
eous reserve requirements not yet implemented,
the Fed’s current approach to discount window
administration actually enhances short-run money
control. Many argue that, once contemporaneous


reserve requirements are instituted next year, this
approach should be abandoned because it will
compromise the Fed’s control over the stock o f
money. They recommend the Fed reduce banks’
incentives to borrow reserves at the discount
window by setting the discount rate well above
short-term market interest rates. But the case for
going to a so-called penalty discount rate is not
clear-cut To assess whether a change in the
discount window procedure would be appropriate,
we must take a closer look at how the discount
window fits into the Fed’s evolving money control

The Fed’s narrowest definition o f money, M l,
includes both currency in circulation and the
balances the public holds in transactions accounts
at depository financial institutions (commercial
banks, mutual savings banks, savings and loans,
and credit unions). These institutions are required by
law to hold reserves in proportion to the balances
in the transactions accounts they issue.1 They
also provide currency when people decide to
withdraw funds from their accounts; to make such
transfers, institutions “ buy” currency from the Fed
with their reserves. So, when the Fed changes the
amount o f reserves it supplies to the financial
system, it changes the amount o f money— currency
and transactions balances— that the financial
system is able to supply to the public.
This does not mean that the Fed can tell exactly
how much the quantity o f money will change when
it changes the supply o f reserves. The outcome
will depend on exactly how financial institutions
and the public react to the change in reserves— in
other words, on supply and demand factors. Based
on previous experience and an assessment o f
current economic and financial conditions, the
Fed can predict how much the quantity o f money is
likely to change when it adds reserves to, or

transactions accounts in M 1 include checking accounts at
commercial banks and mutual savings banks, NOW and ATS
accounts at these institutions and at savings and loans, and
share draft accounts at credit unions. The definition o f M 1 is
given in Table 1.21 o f the Financial and Business Statistics
Section o f each issue o f the Federal Reserve Bulletin.
Depository institutions may hold reserves either as deposits
at the Federal Reserve Bank or as cash in their vaults.


M AY/JUNE 1983

withdraws reserves from, the financial system. But
in the short rum at least the actual outcome is
likely to differ somewhat from the Fed’s expec­

Controlling the Supply o f Reserves
Through Open Market Operations. The Fed
affects the supply o f reserves primarily through its
open market operations, that is, its purchases and
sales o f U.S. Government securities. On average
only about 3 percent o f the total reserves held by
depository institutions are borrowed from the Fed
at the discount window. The other 97 percent are
nonborrowed reserves which the Fed has provided
through open market purchases o f government
securities.2 The Fed’s open market operations can
substantially influence short-term market interest
rates as well, especially the federal funds rate—
the rate at which banks lend reserves to one
another overnight
Each February, the Federal Open Market Com­
mittee (FOMC)— the principal group within the
Fed charged with setting monetary policy— an­
nounces target ranges for growth in M l and several
broader measures o f the money supply over the
course o f the year. At regular intervals, the FOMC
meets to assess the performance o f the monetary
aggregates relative to these ranges. If money growth
has deviated substantially from the long-term
targets, the FOMC typically determines a short-run
strategy for returning money to those targets.
Under the pre-1979 federal funds rate operating
procedure, the FOMC used open market operations
to adjust the federal funds rate to a level thought to
be consistent with returning to its money growth
targets. Under the reserve operating procedure,
the FOMC now uses open market operations to
adjust the amount o f reserves to a level which the
Fed staff estimates to be consistent with the desired
behavior o f money growth.3

■When the Fed buys U.S. Government securities, the supply
o f reserves available to the banking system rises. The Fed pays
brokers for the securities it purchases with checks drawn on the
Fed; the brokers deposit the checks with their banks; the banks
present the checks to the Fed for payment; and the Fed makes
payment by crediting the banks’ reserve accounts in the amount
o f the check. When the Fed sells securities, bank reserves
3For a more detailed discussion o f the Fed’s switch to a
reserves operating procedure and the impact o f this change on
money growth and interest rate behavior, see “The FOMC in


Discount W indow

If the staffs estimates o f banks’ willingness to
supply money and o f the public’s willingness to
hold money (rather than other forms o f assets)
were correct the changes in reserves would work
their way through the financial system, expanding
or contracting the money stock by just enough to
achieve the FOMC’ s money growth target But the
staffs estimates are always subject to some error. So
the supply o f nonborrowed reserves that the Fed
makes available may not keep money growth
exactly on target How far o ff target the money
stock ends up depends not only on how large an
unexpected shift occurred in the behavior o f fin­
ancial institutions or the general public, but also
on how the Fed has deployed its other monetary
policy tools— reserve requirements and the dis­
count window.

Contemporaneous Reserve Require­
ments W ill Strengthen the lin k Between
Reserves and Money, in September 1982, the
Board o f Governors approved a switch to contem­
poraneous reserve accounting in order to strengthen
the relationship between the amount o f reserves
the Fed supplies and the amount o f money the
financial system creates.
The textbook version o f the money supply
process suggests that a bank’s reserve require­
ments are based on the balances currently out­
standing in its customers’ transactions accounts.
But since 1968, the Fed has been using a system of
lagged reserve requirements (LRR). Under this
system, banks meet their reserve requirements by
maintaining a specified average reserve balance
with the Fed each week computed on the basis o f
the average level o f transactions balances held at
the bank two weeks previous. Therefore, the level
o f transactions deposits outstanding in the current
week does not affect banks’ required reserves until
two weeks in the future. Under LRR, if the public’s
demand for transactions balances is exceptionally

1979: Introducing Reserve Targeting,” by Richard W. Lang in
the Federal Reserve Bank o f St. Louis Review, (March 1980), pp.
2-25, and “The FOMC in 1980: A Year o f Reserve Targeting,” by
R. Alton Gilbert and Michael E. Trebing in the Federal Reserve
Bank of St. Louis Review. (August/September 1981), pp. 2-22.
Also see "Federal Reserve System Implementation o f Monetary
Policy: Analytical Foundations o f the New Approach,” by
Stephen Axilrod and David E. Lindsey in the American Economic
Review. Papers and Proceedings vol. 17 (May 1981), pp. 246252.

Herb Taylor

strong in the current week, depository institutions
can meet the higher demand without any immediate
increase in their current w eeks required reserves.
Under the contemporaneous reserve require­
ments (CRR) system scheduled for implementation
in February 1984, depository institutions will face
two- week settlement periods ending with the close
o f business every other Wednesday. But their
reserve requirements for each settlement period
will depend on the amount currently outstanding
in their customers’ transactions accounts.4 So the
average volume o f transactions accounts that the
depository institutions can support during any
settlement period will depend directly on the
amount o f reserves the Fed is willing to supply
over that period.5
CRR will strengthen the link between required
reserves and the volume o f transactions balances,
but it will not forge an ironclad bond between the

4In particular, an institution’s reserve requirements are
computed on the basis o f its average level o f deposits for the
two-week period beginning with the opening o f business the
Monday before the settlement period begins, and ending with
the close o f business on the Monday before the settlement
period closes. Except for a two-day lag, then, an institution’s
current reserve requirements will depend upon its current
deposit level. For a detailed discussion o f the new CRR system
see “The New System o f Contemporaneous Reserve Require­
ments,” by R. Alton Gilbert and Michael E. Trebing in the
Federal Reserve Bank o f St. Louis Review. (December 1982), pp.
5From the perspective o f money control, a weakness o f the
current reserve requirement structure is that not all depository
institutions are required to hold reserves in the same pro­
portion to their outstanding transactions deposits. In addition,
certain types o f time and savings deposits, which are not part of
the narrowly defined money supply, are subject to reserve
requirements. Consequently, the public’s choices o f which
particular depository institutions they will use and o f how
much to hold in various non-transactions type accounts affect
the amount o f reserves the financial system will require to
support a particular volume o f transactions balances.
After an eight-year phase-in period, the Depository Institu­
tion Deregulation and Monetary Control Act o f 1980 (MCA) will
bring the Fed closer to a uniform set o f reserve requirements on
all transactions balances included in M 1, although some d if­
ferences among depository institutions and types o f deposits
will remain. For a detailed presentation o f these requirements
and o f the reserve requirements prior to MCA see Table 1.15 in
the Financial and Business Statistics section o f any recent
issue of the Federal Reserve Bulletin.



M AY/JUNE 1983

Lagged reserve requirements (LRR) weaken the short-run relationship between money and
reserves. As long as LRR remains in place, the only immediate impact open market operations have
on the money stock is through their impact on the federal funds rate. Under these circumstances,
combining a penalty discount rate with a reserve targeting procedure for open market operations
could produce substantial swings in both the federal funds rate and the money stock.
Under LRR, when the Fed must decide on how many reserves to buy or sell in the open market
banks’ reserve requirements for the week have already been determined by the level o f transactions
deposits two weeks previous. No matter how much deposits expand or contract in the current
week, they cannot affect banks’ current reserve requirements. To the fixed amount o f required
reserves, the Fed can add its estimate o f the amount o f excess reserves banks will want to hold and
the amount o f reserves they will need to meet the public’s currency demand in the current week.
This will give the Fed an estimate o f the financial system’s total demand for reserves in the current
week. Then the question is, how much o f this relatively fixed demand for reserves the Fed should
meet through open market operations. One thing to avoid is supplying too many nonborrowed
reserves. Suppose the amount o f reserves supplied through the open market were to exceed the
demand for reserves initially. Some banks with extra reserves to lend in the federal funds market
would find few, if any, banks willing to borrow, even at low interest rates. So the federal funds rate
would begin to fall. Individual banks could rid themselves o f their unwanted excess reserves by
writing more loans. Customers spending the proceeds o f the loans would move the reserves to
other banks. But the extra reserves would still be available to the banking system as a whole. And
even though the loans create more transactions deposits, the additional deposits do not raise the
current weeks reserve requirements. So the funds rate would keep falling and the money stock
would keep growing until, ultimately, banks elected to hold enough excess reserves or the public
elected to hold enough o f the additional money as currency to use up the extra reserves.
To avoid the potential difficulties associated with supplying more reserves than banks demand,
the Fed usually attempts to supply fewer reserves through open market operations than banks
demand, thereby forcing banks to borrow the rest at the discount window. But the Fed cannot use
this strategy and sustain a penalty discount rate. As long as the amount o f reserves the Fed supplies

supply o f reserves and the quantity o f money.
Even after CRR is implemented, the amount by
which money expands when the Fed increases
reserves will still depend on the reaction o f
depository institutions and the public to the added
reserves. And the success o f shifting to CRR also
will depend on the extent to which, and the con­
ditions under which, depository institutions supple­
ment their nonborrowed reserve holdings by bor­
rowing reserves at the Fed’ s discount window.

The Fed decides on the size o f its open market
operations unilaterally, but the volume o f discount
window borrowing represents the interaction o f
the Fed with the depository institutions eligible to
borrow. The Fed establishes the rules and pro­

cedures under which depository institutions may
borrow. The depository institutions seek to use the
borrowing privilege to their best advantage without
violating the rules.
The Fed usually sets the basic discount rate, the
rate at which banks can borrow short-term funds
at the discount window, below prevailing short­
term market interest rates, such as the federal
funds rate. But the Fed does not intend for banks to
use the discount window simply as an inexpensive
source o f funds. Rather the Fed wants banks to
view the discount window as a “ last resort” — a
source o f funds when they face unexpected needs
for funds and have already exhausted all other
reasonable sources. This intention is stated both
in the Fed’s Regulation A, which sets out the
guidelines for discount window borrowing, and in
an explanatory pamphlet on the discount window

Discount W indow

Herb Taylor

in the open market is less than the amount banks need to meet reserve requirements, competition
among banks for those reserves will keep the federal funds rate at least as high as the discount rate.
Even if the Fed were to start out with a relatively high discount rate, so that it initially imposed an
interest penalty on borrowing, the relative shortage o f nonborrowed reserves would force the
funds rate higher and higher until it finally broke through the “ penalty” rate, and borrowing filled
the gap between the demand for reserves and supply o f nonborrowed reserves.
So with LRR still in place the Fed generally maintains a discount rate below the federal funds
rate. In fa ct the Fed uses the sensitivity o f borrowing to the federal funds rate, which a relatively
low discount rate provides, to help control the money stock in the short run. The fewer reserves the
Fed supplies in the open market the more banks are forced to borrow at the window. Based on
previous experience, the Fed can estimate how high the funds rate will have to go to generate the
expected or desired level o f borrowing. It can then estimate how much money the financial system
will be willing to create, and the public will be willing to hold, at that funds rate. So the link between
banks' discount window borrowing and the spread o f the funds rate over the discount rate allows
the Fed to use its reserve operating procedure to influence the money supply in the short run, even
with LRR.
Keeping a relatively low discount rate has an advantage for short-run money control when the
unexpected happens as well under LRR. If banks unexpectedly change their willingness to borrow
at the window or their desire to hold excess reserves, or if the pubic decides on an unexpectedly
large proportion o f currency in its money holdings, the interest-sensitive discount window helps
minimize the impact o f these changes on the prevailing funds rate and hence, as under CRR, helps
minimize their impact on the outstanding money stock. And if the public’s demand for money
unexpectedly shifts under LRR, banks’ decisions to accommodate the shifts will not affect their
current demand for reserves, as it does under CRRa

aA recent study o f discount rate policy under reserve targeting is "The Impact o f Discount Policy Procedures on the
Effectiveness o f Reserve Targeting” by Peter Keir in New Monetary Control Procedures. Federal Reserve Board Staff Study,
Volume I, (February 1981).

that the Fed provides to eligible depository institu­
While the Fed frowns on the notion o f borrowing
for profit, the guidelines themselves are extremely
broad, and the discount officer at each Federal

6“The Federal Reserve Discount Window” , Federal Reserve
Publication, (October 1980).
The Fed lends reserves to banks primarily through its adjust­
ment credit program, and it is with adjustment borrowing that
the present discussion is concerned. In September 1980, the
Fed amended Regulation A to establish an extended credit
program under which depository institutions could borrow for
longer periods than under the adjustment credit program. The
amounts borrowed and numbers o f institutions involved thus
far have been relatively small. For a discussion o f the extended
credit program, see Janice M. Moulton, "Implementing the
Monetary Control Act in a Troubled Environment For Thrifts,”
this Business Review, (July/August 1982) pp. 13-21.

Reserve Bank has the discretionary authority to
decide on the appropriateness o f each borrowing
request This discretionary procedure imposes
costs on banks that borrow— the costs of providing
information to, and negotiating with, the Federal
Reserve Bank. These costs have proven sufficient
to keep most banks away from the window, even
when market rates are substantially higher than
the discount rate.
When banks do decide to come to the discount
window, the Fed’s administrative procedures
typically serve to limit their borrowing. If a parti­
cular institution exhibits a well-defined pattern of
borrowing, borrows frequently, or borrows in rela­
tively large amounts, the Fed becomes concerned
that some o f the institution’s borrowing may be
inappropriate, and subjects each additional request
for borrowing to closer scrutiny. Ultimately, such a



borrower may be turned down and told to avoid the
window for “ an extended period.” In short the
more a bank borrows at the discount window, the
more costly each additional dollar o f borrowing
becomes. The explicit interest rate the bank pays
on each dollar— the discount rate— stays the same,
but the implicit costs it must bear— including the
potential costs o f impaired future borrowing privi­
leges— rise with each additional dollar borrowed.
These rising costs o f borrowing limit the amount
that banks choose to borrow at the discount window.
The profit-seeking bank will borrow only up to the
point where the costs o f borrowing another dollar
would more than offset the gain, as measured by
the spread between market interest rates and the
discount rate.
Of course, the wider the spread between market
rates and the discount rate the greater the benefit
from each dollar borrowed, and the more worth­
while borrowing at the discount window becomes.
Economists find that borrowings rise significantly
as the federal funds rate rises above the basic
discount rate. When the federal funds rate falls
below the discount rate, adjustment borrowing
typically drops to minimal levels (see Figure l).7
Thus, as long as the discount rate is below the
federal funds rate, borrowing is “ interest-sensitive.”
But when the discount rate is above the federal
funds rate, as would be the case under a penalty
discount rate, borrowing is not “interest-sensitive.”
It might be argued that the Fed’s current adminis­
trative procedures are not particularly efficient for
achieving the stated purpose o f the window. If the
Fed were simply to keep the discount rate above
the prevailing funds rate, the incentive for inappro­
priate borrowing would be eliminated and the Fed

7A study by Stephen M. Goldfeld and Edward J. Kane, "The
Determinants o f Member Bank Borrowing: An Econometric
Study,” Journal o f Finance vol. 21 (1966), pp. 499-514, is often
cited as the classic analysis of banks’ discount window behavior.
For empirical estimates o f the borrowing relationship based on
more recent data see, for example, the equations estimated in
"Policy Robustness: Specification and Simulation o f a Monthly
Money Market M odel,” by Peter A. Tinsley, and others, in the
Journal o f Money. Credit and Banking, vol. 14 part 2, (November
1982) pp. 830-856, and in “ Detecting and Estimating Changing
Economic Relationships: The Case of Discount Window
Borrowings,” by D.H. Resler, J.R. Barth ind P.A.V.B. Swamy,
Federal Reserve Board Special Studies P

could dispense with its complicated administration
o f the discount window. With the discount rate set
at a penalty level, a bank naturally would seek
adjustment credit only when it unexpectedly
needed funds and could not raise them from its
usual market sources, just as the Fed intends.
The important question is whether the sensitivity
o f borrowing to movements in the federal funds
rate, produced by setting a relatively low discount
rate, improves or weakens the Fed’s control over
the money stock. Under the reserve operating
procedure, once the FOMC has decided on a money
growth target the Fed staff must estimate how
many nonborrowed reserves must be supplied in
order to achieve that target First the Fed staff
must estimate how much o f the targeted money
stock the public will choose to hold as currency
and how much as transactions balances at deposi­
tory institutions. They can then determine how
many reserves banks will need in order to provide
the currency demanded and to meet the reserve
requirements against the transactions balances.
(Under CRR, required reserves will change as soon
as transactions balances change.) To that amount
the staff must then add its estimate o f the amount
of reserves banks will need to meet reserve require­
ments on certain nontransactions balances and its
estimate o f the amount o f excess reserves banks
will want to hold. This gives an estimate o f the total
amount o f reserves the Fed must supply to meet its
money stock goal. The staff then subtracts the
amount o f reserves that the FOMC judges banks
will borrow at the discount window, yielding a
target for the nonborrowed reserves to be supplied
through open market operations.
As long as all o f the Fed’s estimates are accurate,
the reserves it supplies through the open market
will keep the money stock on target, regardless of
the particular discount window policy in e ffe c t It
is when the Fed’s estimates are o ff that discount
window administration matters. Would a discount
rate below the federal funds rate, which keeps
borrowings sensitive to federal funds rate changes,
help minimize the impact o f such errors on the
money stock, or would a penalty discount rate do a
better job? That is not an easy question to answer;
it depends on the source o f the error. The amount
o f money* i the hands o f the public is, as
economists^ e fond o f saying, a matter o f supply
The argument for going to a penalty

Federal Reserve Bank

of St. Louis


Herb Taylor

Discount W indow

willingness or ability o f the financial system to
supply money, then an interest-sensitive discount
window would help minimize the impact o f the
error on the actual money stock. Such an error
could occur for several reasons. The public may
choose to hold an unexpectedly large ratio of
currency relative to transactions accounts, or
choose to hold more in reservable nontransactions
accounts than the Fed had expected. Banks may

discount rate hinges on the Fed’s finding it easier
to predict how much money the financial system
will be willing and able to supply than it is to predict
how much money the public will demand.

If the Fed makes an error in assessing the


4 gBiliB-B-BB|m „

Billions o f Dollars

^ —



Discount W indow Borrowing
(right scale) -

(left scale)








aThe monthly average o f total discount window borrowing less borrowing under the extended credit program.
^The monthly average o f the federal funds rate less the sum o f the basic discount rate plus the surcharge. During two
separate periods in 1980 and 1981, the Fed imposed a surcharge on adjustment borrowing by institutions with $500 million
or more in deposits that borrowed in successive weeks or more than four weeks in a calendar quarter. For a good discussion
o f the surcharge’s impact, see "The Discount Rate: Experience Under Reserve Targeting," by Gordon H. Sellon, Jr. and
Diane Seibert in the Federal Reserve Bank o f Kansas City Economic Review (September-October 1982), pp. 3-18.



want to hold more excess reserves than the Fed
had anticipated, or they may start out less willing
to borrow reserves at the discount window than
the Fed thought they would be. Any o f these
circumstances would leave the financial system
with fewer reserves available to meet reserve
requirements on transactions balances than the
Fed had expected. With CRR, that means more
reserves would have to be added in the current
settlement period in order to keep transactions
accounts, and hence the quantity o f money, from
falling below target An interest- sensitive discount
window would keep money closer to target by
inducing banks to borrow more reserves to make
up the shortfall.
Suppose, for example, individual banks unex­
pectedly decide to hold more excess reserves. As a
result, the demand for reserves is greater than the
Fed expected, and competition for the available
reserves puts unexpected upward pressure on the
federal funds rate. The higher funds rate widens
the positive spread on discount window borrowing
when the discount rate is below the federal funds
rate. This, in turn, induces banks to step up their
borrowing from the Fed, thereby increasing the
quantity o f reserves supplied and bringing the
money supply back up towards target
Similarly, the impact o f any unexpected increase
in the ability o f the financial system to supply
money— such as a smaller than expected ratio o f
currency to transactions accounts ratio, or a sudden
decrease in excess reserve holdings— would be at
least partly offset if the Fed were to maintain a
discount rate below the federal funds rate. The
interest-sensitive discount window that this policy
produces would tend to reduce the quantity o f
reserves supplied and help keep the money stock
from overshooting its target
Under a penalty discount rate, any errors the
Fed makes in estimating the strength o f the financial
system’ s willingness and ability to supply money
also would produce unexpected movements in the
federal funds rate. But as long as the discount rate
is kept above the funds rate as it changes, these
funds rate movements would not generate a posi­
tive spread on discount window borrowing, and
would not affect the level o f borrowing and the
total supply o f reserves. The money stock would
proceed unexpectedly o ff course. Thus, the more
uncertain the Fed is concerning the behavior o f


the financial system in supplying money, the less
desirable a penalty discount rate is. However, if the
Fed’s uncertainty is instead about the public’s
demand to hold money balances, then a penalty
rate may be advantageous.

When choosing the appropriate level o f open
market operations, the Fed must consider the
public’s demand for money as well as the factors
affecting the financial system’s ability to supply
money. In estimating the demand for money, the
Fed can take advantage o f certain stable economic
relationships: the public’s demand for money
depends fundamentally on the level o f economic
activity and the level o f interest rates. But the Fed’s
estimates o f money demand are still subject to
In our economy, few transactions involve the
direct exchange o f goods and services; almost all
involve the exchange o f goods or services for
money. So the greater the volume o f transactions
households and businesses intend to carry out,
the more money they will want to have on hand.
Since the overall volume o f transactions rises and
falls with the volume o f goods and services bought
and sold, economists find a strong direct relation­
ship between the quantity o f money the public
demands and measures o f economic activity such as
gross national product: as GNP rises, so does the
quantity o f money demanded.
On the other hand, economists find an inverse
relationship between interest rates and the quantity
o f money people want to hold: as interest rates
rise, the quantity o f money demanded declines.
Money offers its holder the convenience o f making
market transactions right away, but it pays either
no interest or low interest compared to the rates
being paid on alternative short-term financial
instruments. So as the rates on short-term instru­
ments rise, people have an incentive to econom ize
on their money holdings and buy more o f these
instruments. Consequently economists find that
the quantity o f money the public demands moves
inversely with the general level o f interest rates.
The relationship o f money demand to levels o f
economic activity and interest rates helps the Fed
assess the likely strength o f that money demand.

Discount W indow

But the relationships are not known with precision.
Even if they were, the Fed’s assessments still
would be subject to error simply because data on
the economy’s performance are not immediately
available. Futhermore, other factors affect the
public’s demand for money. Some factors, such as
seasonal influences, the Fed finds relatively easy
to predict But other factors, such as the impact of
technological or financial innovations, are more
difficult to predict So for a variety o f reasons, the
Fed’s money demand forecasts are far from pre­
cisely correct.
When the Fed errs in assessing the strength o f
the public’s demand for money, a relatively low
discount rate, which keeps borrowing sensitive to
funds rate changes, magnifies its impact on the
quantity o f money. On the other hand, a penalty
discount rate, which keeps bank borrowing from
responding to funds rate changes, virtually elimi­
nates the impact o f such a forecasting error on the
stock o f money.
Suppose, for example, that a sudden increase in
the level o f economic activity causes an increase
in the public’s demand for money which the Fed
did not expect when it decided how many nonborrowed reserves to supply. As banks accom­
modate their customers’ demands, outstanding
transactions balances at the banks grow. Under
CRR, the banks must now hold additional reserves.
They go to the federal funds market to procure the
reserves and the increased demand for reserves
begins to bid up the federal funds rate. What
happens next depends on the Fed’s discount rate
If the Fed has set the discount rate below the
funds rate, the rising funds rate opens up a larger
spread and automatically induces some banks to
borrow more at the window. If borrowing is ex­
tremely sensitive to the spread, then, with just a
very small increase in the federal funds rate, the
discount window will provide nearly all the reserves
needed to meet the reserve requirements on the
additional transactions balances the public
demands. In that case the Fed would overshoot its
targeted money supply by an amount almost equal
to the unexpected increase in money demand. If
borrowing is less sensitive to the spread (but the
discount rate is still not a penalty rate), then the
unexpected increase in the funds rate will be
larger, and the unexpected increase in total reserves

Herb Taylor

will be smaller, but the surge in money demand
still will cause some overshooting o f the FOMC’s
money target.
Suppose, on the other hand, that the Fed had set
the discount rate at a level well above the federal
funds rate. As before, in response to the surge in
money demand, banks come to the funds market
to obtain more reserves and the funds rate begins
to rise. But as long as the discount rate is kept
above the funds rate, the spread remains negative
and banks have little incentive to increase their
borrowing from the Fed, so total reserves do not
grow. Meanwhile, the rising funds rate is making it
more expensive for banks to meet reserve require­
ments on transactions balances. Consequently,
banks begin to raise the rates they charge on loans.
In addition, they try to induce the public to hold
more o f the instruments on which there are no
reserve requirements by offering higher interest
rates on those instruments. Thus, higher market
interest rates work to reduce the amount o f money
that the public wants to hold, restoring it to the
amount that the Fed had initially expected. By
setting a penalty discount rate then, the Fed allows
rising interest rates— a rising funds rate, rising
loan rates, rising rates on other instruments— to
choke o ff the impact o f an unexpected increase in
the public’s demand for money and thereby keeps
the money supply on target.
In the face o f an unexpected decline in the
public’s demand for money, setting a penalty
discount rate enjoys a similar advantage over a
discount policy that keeps the discount rate
relatively low. W ith CRR, the initial decline in
money demand immediately reduces the demand
for reserves and hence, the funds rate. If the
discount rate is kept below the funds rate, discount
window borrowings fall, total reserves fall and the
actual money stock falls below target. But if the
discount rate had been set at a penalty level, the
declining funds rate would not reduce borrowing
any further, so the supply o f reserves would remain
unchanged, and generally falling interest rates
would work to maintain the amount o f money the
public is willing to hold at the targeted level.
In short, when the Fed makes errors in fore­
casting the public’s demand for money, maintain­
ing a penalty discount rate forces market interest
rates, rather than the money stock, to make the
adjustment So when these errors occur, interest


rates will rise or fall by more than the Fed had
expected, but the money stock will remain closer
to the target the Fed had s e t8

Over the past several years, the Fed has been in
the process o f reworking its major policy tools so
that its control over the supply o f reserves will
produce better control over the nation’s stock of
money. First the FOMC restructured its procedures
for controlling money growth by focusing the
conduct o f open market operations on the supply
o f nonborrowed reserves rather than on the level
o f the federal funds rate. More recently, the Board
of Governors adopted a system o f contemporaneous
reserve requirements that will tighten the shortrun relationship between reserves and the amount
o f money the financial system creates. Nonetheless,
elements o f unpredictability will remain in the
monetary control process.
Would maintaining a penalty discount rate
eliminate these elements o f unpredictability?
Unhappily, it would not eliminate them entirely. In
the face o f unexpected shifts in the public’s
demand for money, keeping a penalty discount
rate would reduce the magnitude o f unexpected
movements in the actual money stock. But when
unexpected shifts occur in the willingness and
ability o f the financial system to supply money, a
penalty discount rate would amplify their impact
on the money stock. So a penalty rate would
provide better money control only to the extent
that the Fed finds it more difficult to predict the

8The problem o f how the discount window fits into the
money control process is given a graphical treatment in, “The
Role o f the Discount Rate in Monetary Policy: A Theoretical
Analysis,” by Gordon H. Sellon in the Federal Reserve Bank o f
Kansas City Economic Review (June 1980) pp. 3-15 and "Should
the Discount Rate Be A Penalty Rate?” by J.A. Cacy, Bryon
Higgins and Gordon H. Sellon, Jr. in the Federal Reserve Bank
o f Kansas City Economic Review (January 1981) pp. 3-10. For a
mathematical approach, see “ Simple Analytics o f the Money
Supply Process and Monetary Control," by Daniel Thornton in
the Federal Reserve Bank o f St. Louis Review (October 1982) pp.



public’s demand for money than to predict the
financial system’s willingness and ability to supply
Other proposals for discount window reform
have been made with the aim o f achieving a balance
between the current administrative procedures
and setting a penalty discount rate. Their aim is to
reduce, rather than virtually eliminate, the interestsensitivity o f discount window borrowing.9 One
suggestion is to maintain a relatively low discount
rate, but to increase the additional costs imposed
on large or frequent borrowers, either by tightening
District Banks’ administrative procedures for
handling banks’ borrowing requests or by imposing a
system o f graduated surcharges on heavy borrowers.
Another approach is to prevent federal funds rate
movements from creating too big a spread between
the funds rate and the discount rate by adopting a
formula for adjusting the discount rate automati­
cally as market rates fluctuate.
In short, once CRR is in place, reworking discount
window procedures might very well improve the
Fed’s short-run control over the money stock. But
determining whether a penalty rate would improve
money control, or how much o f an improvement
the various compromise alternatives would make,
must await an assessment o f the predictability of
the public’s demand for money and the predicta­
bility o f the financial system’s willingness and
ability to supply it

9Some o f these proposals also are intended to make the
degree o f interest-sensitivity to borrowing more certain. It is
important to note that in choosing among alternative proposals
for discount window reform, improved money control may not
be policymakers’ only criterion. A penalty discount rate, for
example, may make short-run money growth more predictable
while making short-term interest rate movements larger or
more volatile. So if policymakers are concerned about the
magnitude or variability o f interest rate movements, then this
complicates the choice o f discount window policy. On the
other hand, by maintaining a discount rate below short-term
market interest rates, the Fed subsidizes the banks that do borrow
at the window. So if policymakers are concerned about the
extent to which borrowing banks are receiving a subsidy, then
this also may influence their choice among discount window


When Is the Prime Rate
Second Choice?
by Brian C. Gendreau*

Not long ago, little controversy surrounded the
prime rate convention. The prime rate was under­
stood to be the rate banks charged on loans to their
most creditworthy corporate customers. Other
corporate borrowers paid a rate marked up over the
prime. Though prime-related loans were generally
floating-rate loans— such that borrowers’ loan rates
changed with the prime— the prime rate usually
rose and fell gradually, giving customers a measure
o f stability in their borrowing costs.
Banks still post prime rates, and changes in the
prime continue to be reported on national news­
casts and greeted by bursts o f trading activity in
securities markets. But now the prime seems to
change faster in response to market interest rate
movements. Moreover, many loans are being
made at rates below the prime. According to a
Federal Reserve Board survey o f the terms o f all
short-term business loans granted by 48 o f the

'Associate Economist in the Banking Section o f the Research
Department o f the Federal Reserve Bank o f Philadelphia.

nation’s largest banks, in the first week o f Nov­
ember, 1982, over 92 percent were at rates below
the prime.
Consequently, many commentators now doubt
that the prime is a useful benchmark loan rate.
After the staff o f the House Banking Committee
studied lending practices at ten large banks in
early 1981, Chairman Ferdinand St. Germain
concluded that “ the prime rate has been so often
misused, abused, and tortured in recent years that
the phrase now seems beyond repair.” Secretary o f
the Treasury Donald Regan concurs that the prime
rate no longer reflects loan costs accurately, and
recently proposed creating in its stead a “watch rate”
set at half a percentage point above the com­
mercial paper rate— the interest rate firms pay on
short-term notes sold in money markets. Why
have bank lending practices changed? What kinds
o f loans are being made below prime? What does
the prime rate mean today? The answers depend in
part on the characteristics o f the prime, and
especially on the manner in which prime rate
changes are determined.

MAY/JUNE 1983


Popular definitions o f the prime rate usually
distinguish it from other rates by the credit quality
o f the underlying loan. The prime rate also differs
importantly from other interest rates, however, in
the way it reacts to changes in credit market
conditions. W hile rates on money market instru­
ments such as Treasury bills and commercial paper
change with trading throughout each day, the
prime rate changes less frequently. In past years,
when interest rates were more stable, the prime
rate did not change for months or even years on
end. Now the prime rate changes more often, but it
still lags changes in market rates.
The stickiness in the prime rate is easily seen in
Figure 1, which compares the movements o f the
prime rate, the 3-month commercial paper rate,
and their difference from 1972 through 1982. The

prime rate adjusts fully to short-term interest rate
movements, but only after a substantial lag. When
short-term rates rise, the prime rate initially
does not keep pace, and the spread between the
prime and short-term rates narrows and occasion­
ally becomes negative. Conversely, when interest
rates fall, the prime rate lags behind, and the
spread between the prime and market rates widens
The stickiness in the prime rate can be traced to a
corresponding stickiness in banks’ cost o f attract­
ing new funds from so-called core deposits— demand
deposits and those time deposits subject to binding
interest rate ceilings. Since Congress prohibited
the payment o f interest on demand deposits and
authorized the Federal Reserve to limit the rates
paid on time deposits in the Banking Act o f 1933,
banks have competed for core deposits by paying
implicit interest in the form o f services provided












Brian C. Gendreau

Prime Rate

below cost These services, which are provided on
core deposits to this day, include check clearing,
gifts, the convenience of a multitude o f bank
branches, extended hours, credit lines, and, for
firms, payroll and cash management systems (see

Banks Adjust Implicit Deposit Rates
Slowly. . .When interest rates are low and stable,
banks have little difficulty in attracting core
deposits by paying implicit interest. But when
interest rates move higher and become more var­
iable, bank deposit and loan pricing becomes
more complicated. The problem is that implicit
interest payments cannot be changed quickly in
response to interest rate movements. It takes time
to build new branches, to run or pull advertising
campaigns, to mail out notices o f changes in service
charges (and to decide to do these things). Banks
cannot hope to match frequent fluctuations in
short-term interest rates with costly, cumbersome
changes in services. Nonetheless, banks that fail
to adjust their implicit interest payments to meet a
permanent change in market rates risk losing
Unable to change services quickly, yet com­
pelled by competition to match eventually a sus­
tained change in market rates, banks have little
choice but to adjust implicit interest payments

gradually to changes in market interest rates.
Economists’ estimates o f the implicit interest rates
paid by banks are consistent with this kind o f rate
setting behavior. Two estimated implicit interest
rate series are presented in Figure 2 (p. 16). These
estimates show that implicit rates respond to
changes in market rates, but do not adjust on a
one-to-one basis with changes in current period,
short-term interest rates.1
.. .Making the Prime Rate Sticky, in seeking
to maximize profits, banks adjust their loan rates
to reflect changes in their costs in raising new
funds. As long as some o f these funds are obtained
by paying implicit interest on core deposits, banks’
costs in attracting additional funds will change
only gradually in response to market rate move­
ments. Since loans are priced as a markup over

1See Richard Startz, "Implicit Interest on Demand Deposits,”
Journal o f Monetary Economics, 5 (1979), pp. 515-534, and
Edward J. Stevens, “ Measuring the Service Return on Demand
Deposits,” Federal Reserve Bank o f Cleveland Working Paper
No. 7601 (December, 1976). Startz’s series is an estimate of the
average implicit interest rate paid on all demand deposits, and is
available through 1976. Stevens' series is an estimate o f the
implicit rates paid to attract extra (marginal) demand deposits,
calculated under the assumption o f perfect competition, and is
available through 1974.

An industry-wide prime rate first emerged in 1934, shortly after Congress prohibited the payment o f
interest on demand deposits. Banks, having suffered three consecutive years o f losses (in the aggregate) by
1934, welcom ed the legal restrictions against deposit rate com petition and began to com pete for deposits by
paying im plicit interest in services, as they do to this day. The timing o f the inception o f the prime rate suggests
that the prime is closely connected to nonrate deposit competition. Buy why would banks prefer nonrate to
rate competition? And how is the prime linked to nonrate competition?
W hen banks engage in interest rate com petition for deposits, they must pay the com petitive rate on all
deposits. This rate is highly visible, and can be compared with other banks’ rates with ease. In contrast with
nonrate com petition customers must undertake a costly search among banks to find the best loan and deposit
service bundles. Once interest rate com petition is prohibited, banks can take advantage o f the imperfect
inform ation customers have about each other’s services to reduce services below the com petitive level.
Moreover, by com peting for deposits with services banks are able to reduce their costs by offering less in
services to customers who are relatively insensitive to the return on their deposits than to more returnsensitive customers.
The prime rate is connected with nonrate deposit com petition because many bank depositors are also
borrowers. The most effective way to pay im plicit interest to depositor-borrower customers is through loan
rate concessions. W idespread loan rate concessions, however, would have wiped out the benefits o f nonrate
com petition provided by deposit rate ceilings. Hence banks attempted to preserve nonrate com petition by
adopting a uniform rate for loans to their best customers— the prime rate— that served as a floor rate for
industry-wide loan pricing.


MAY/JUNE 1983



The 4-to 6-month commercial paper rate.


marginal im plicit
demand deposit rate

Estimated average implicit
demand deposit rate (Startz).










SOURCE: See footnote 1 in the text.

these costs, loan rates will also change gradu­
In the process o f adjusting their loan rates,
banks use the prime rate as an industry-wide
pricing guide. Because there is no objective indi­
cator o f when bank costs have changed permanent­
ly, banks are likely to disagree over when the prime
rate should change. But once a large money center

An added benefit to banks in making loan rates more in
tandem with their costs o f raising new funds from all sources is
that by following such a strategy bank earnings will be un­
affected by interest rate movements. Slow loan and deposit rate
adjustment, moreover, is consistent with empirical evidence
that, on the whole, bank profits are not very responsive to
changes in market interest rates. See Mark J. Flannery, “How Do
Changes in Market Interest Rates Affect Bank Profits?” this
Business Review (September-October, 1980) pp. 13-22.


bank has signaled its judgment that a given level of
interest rates will be sustained by changing its
prime rate, and other banks have ratified that
change, a new guideline exists for loan pricing.

Throughout the post-war period, the critical
ingredient in banks’ slow deposit and loan rate
adjustment was their ability to attract core deposits
when market rates were rising relative to implicit
interest rates, and to retain loan customers when
money market rates were falling relative to the
prime rate. Though banks could not adjust services
quickly to short-term interest rate fluctuations,
they did attempt to attract deposits by offering a
stable level o f services that was attractive, on
average, over the interest rate cycle. In some

Prime Rate

periods— particularly when interest rates were
rising— implicit interest rates on core deposits fell
below short-term market rates. But in periods o f
falling interest rates, implicit interest payments
remained high relative to short-term money market
returns.3 Similarly, because the stickiness in
implicit deposit rates was reflected in the prime,
banks gave prime borrowers rates that were com­
petitive with market rates, on average, over the
interest rate cycle: borrowers’ relatively high bank
loan rates in periods o f falling market rates were
followed by comparatively low loan rates in periods
o f rising market rates.
When interest rates were low and stable, banks’
strategy o f competing for customers by offering
deposit and loan products that were attractive on
average relative to market rates was successful.
Temporarily uncompetitive rates relative to market
rates on bank deposits or loans were likely to be
offset by more than competitive rates in the future,
and the differences were not large enough to
induce customers to search for more attractive rates
in money markets.

Volatile Interest Rates Brought Com ­
petition From Money Markets. As interest
rate swings became sharper and wider in the
1970s, however, more and more customers became
dissatisfied with the slow rate adjustment on core
deposits and on prime-related loans. Increasingly,
customers bypassed banks to borrow and lend
directly in money markets.
On the deposit side, customers shifted out of
core deposits into money market instruments,
such as commercial paper, with each big swing in
short-term market rates above the implicit deposit
rate. These shifts can be seen in Figure 3 (p. 18),
where the ratio o f commercial paper to demand
deposits outstanding together with the spread
between the 4-to-6 month commercial paper rate
and estimates o f the implicit rate paid on demand
deposits have been graphed from 1960 to 1976.

^Twice in the 1970s money market rates fell below passbook
savings account rates. Because banks also paid implicit interest
on savings deposits, these deposits must have been quite
attractive to customers in these periods. For an analysis re­
conciling temporarily high core deposit costs with bank profit
maximization, see Mark J. Flannery, "Retail Bank Deposits as
Quasi-Fixed Factors o f Production,” American Economic Review.
72, (June 1982), pp. 527-536.

Brian C. Gendreau

Initially, most o f these shifts were by corporations.
The rapid growth o f money market mutual funds
after the mid-1970s, however, facilitated house­
holds’ shifts out o f core deposits by opening the
money markets to small investors previously un­
able to buy large denomination financial instru­
ments. Once investors overcame costs involved in
placing their funds in money markets, they never
went back to holding as much o f their assets in the
form o f core deposits, as reflected in the steady
decline in the share o f core deposits among large
bank liabilities visible in Figure 4 (p. 19).
On the loan side, the spreads between the
sluggish prime and the commercial paper rate
widened to several hundred basis points during
declines in market rates in the 1970s and 1980s,
motivating large firms to incur the startup costs
necessary to tap the money markets. About 500
new companies began to issue commercial paper
in the years after 1974, boosting the amount of
paper outstanding in that market from $50 billion
in 1974 to almost $180 billion by mid-year 1982.4

Banks Responded By Moving Towards
Market Rate Pricing. To replace the core
deposits that could no longer be relied upon as
their principal source o f loanable funds, banks
issued liabilities carrying market rates o f interest
such as domestic and Eurodollar certificates of
deposit (CD’s), money market certificates, and
federal funds. By 1981, large banks were raising
more than half their funds from interest-sensitive
liabilities. As banks attracted fewer funds from the
core deposits that were responsible for the sluggish­
ness in deposit costs, they changed their loan rates
faster in response to fluctuations in market interest
rates. The average lag in the response o f the prime
rate to money market rates fell markedly between
1970 and 1982, from over 8 weeks in the early
1970s to slightly over 4 weeks in the 1979-1982
period (see the TECHNICAL APPENDIX, p. 22).
In addition to speeding up the pace of prime rate
changes, banks hastened their move towards
market rate loan pricing by offering loans tied to
money market rates to customers with the ability
to draw on the commercial paper market. These
new loans— called money market loans— are

4See Evelyn M. Hurley. "The Commercial Paper Market Since
the Mid-Seventies,” Federal Reserve Bulletin (June 1982).


MAY/JUNE 1983



Ratio o f commercial paper
to demand deposits outstanding
at all commercial banks.

The spread between
the 4-to 6-month com mercial paper rate


and Startz’ s estimate o f the im plicit dem and
deposit rate.


The spread between the 4-to 6-month commercial paper rate
and Stevens’ estimate o f the im plicit demand deposit rate.










SOURCE: See footnote 1 in the text

typically for short maturities (one month or less),
and are matched by the bank to the size, rate, and
maturity o f a specific liability. A bank may, for
example, issue a 30-day CD and use the funds to
make a 30-day loan to a customer at a fixed rate
over the CD rate. By matching the loan to a specific
liability with the same maturity, bank earnings on
the transaction are unaffected by interest rate
fluctuations over the life o f the loan. When the
loan matures, the liability matures, too, and a new
transaction can be made at the new market rates.5
Money market lending is often carried out in close
cooperation with the bank’s financial instrument
trading desk to ensure that the pricing and maturity

matching on the transaction are precise. Because
the rate on money market loans must be close to
money market rates to be competitive, bank profit

5Not all money market loans are fixed-rate credits. Indeed,
banks are now offering large customers an exotic variety o f
loans pegged to different short-term rates and adjustable
(repriced) at different intervals. For example, some banks are
making five-day loans with rates pegged to the daily federal
funds rate. Others are making o n e year loans priced as a
markup over the 3-month Treasury bill rate, but repriced
quarterly. These hybrid credits are likely close substitutes for
and have rates highly correlated with those on the more
numerous fixed-rate, short-term credits. No distinction is made
in the text among the varieties o f money market loans.


Prime Rate

Brian C. Gendreau

margins are small, and large transactions are
necessary to cover the costs o f arranging the loan.

In experimenting with money market lending in
recent years, banks have offered corporate cus­
tomers with good credit standing a choice between
a variety o f short-term credits tied to money
market rates as well as prime-related loans with
longer maturities. Given the stickiness in the
prime rate, it was inevitable that rates on short­
term loans tied to money market rates would fall
below the prime when interest rates declined. In
those periods, firms tried to reduce their borrow­
ing costs by taking fixed-rate, short-term credits
instead o f prime-related loans. The responsive­
ness o f fixed-rate borrowing to the spread between
the prime and the 30-day commercial paper rate
can be seen in Figure 5 (p. 20). The peaks in the
proportion o f large loans made with fixed rates
occurred when the commercial paper rate fell
below the prime. The peaks in fixed-rate lending in
Figure 5 also mark periods o f widespread belowprime lending. In both the first weeks o f May, 1980
and November, 1981, for example, the weighted
average rate on all commercial loans at surveyed
banks was below the ruling prime rate. In those
weeks the prime rate was over 800 basis points and
330 basis points, respectively, above the 30-day
commercial paper rate. Given these cost differ­
ences, it should not be surprising that customers
with the ability to take out loans at money market
rates did so.
The recent episodes o f fixed-rate lending and
below-prime lending cannot be dismissed as mere
aberrations from normal prime-related lending
patterns. Since late 1979, as Figure 5 shows, a trend
towards more below-prime lending developed at
large banks, reflecting the trend toward more
fixed-rate lending in large credits. Yet it would be
premature to conclude that the prime rate is no
more than an artifact of past lending practices.
Assuming that the majority o f floating-rate loans
are prime-related, and that most large fixed-rate
loans represent money market credits, Figure 5
shows that in many periods large banks make more
floating-rate loans (in dollars o f credit extended)
than money market loans, and that even in periods
o f massive fixed-rate lending large banks still


Percent o f Total Liabilities

















































Data are for Large W eekly Reporting Banks
with Assets o f $2 billion or more in 1972 dollars as
o f June o f each year.

aInterest-sensitive funds are defined as the sum of
federal funds purchased, time deposits in accounts of
$100,000 or more, and other borrowings (including
liabilities to foreign branches as a proxy for Eurodollar
SOURCE: Weekly Report o f Assets and Liabilities for
Large Banks, Board o f Governors, Federal Reserve


MAY/JUNE 1983



Ratio o f the prime rate
to the 30-day commercial paper rate






l / / *S

. -v
Percentage o f fixed-rate loans
made at 48 large banks

Percentage o f below-prime loans made at 48 large banks








SOURCE: Federal Reserve Bulletin and unpublished portions o f the Survey o f Terms o f Bank Lending.

make some prime-related loans.6 Data collected in
the Federal Reserve’s Survey o f the Terms o f Bank
Lending indicate, moreover, that fixed-rate lend­
ing and below-prime lending are not as widespread
at small and medium-sized banks as at large
The reason prime-related loans coexist with

6N o data are available on the quantities o f prime-related and
money market loans. Conversations with bankers, however,
indicate that most floating-rate loans are tied to the prime rate.
Though not all fixed-rate credits are short-term money market
loans, the fixed-rate credits of $1 million or more graphed in
Figure 5 generally had average maturities o f one month or less,
and thus may be considered money market loans.


money market loans is that not all loan customers
can substitute money market loans for primerelated credits, and those who can do not find
them to be perfect substitutes. Prime-related loans
today, as in past years, are generally floating-rate
loans, usually repaid in 60 to 90 days, that are used
as working capital by businesses.7 A firm will not
substitute money market loans or commercial

7 Prime-related loans are commonly made with a variety of
fixed maturities, as well as on demand. A precise average
maturity for prime-related loans thus cannot be provided.
Survey data and conversations with bankers, though, indicate
that 60 to 90 days is a reasonable approximation o f the normal
effective maturity o f prime-related loans.


Prime Rate

paper for prime-related loans if its funding needs
are small, because only large money market credits
and commercial paper issues will overcome the
fixed costs o f going to the market. If a firm’s credit
is less than impeccable, it will not be able to sell its
commercial paper, and will have little power in
bargaining for a money market loan from its bank.
Even firms with funding needs and a credit standing
allowing them to obtain money market loans will
not always do so, because it is not always clear that
a string o f short-term credits at market rates will be
less expensive than a single prime-related loan. If
interest rates were to take an unexpected upturn
over the firm’s borrowing horizon, for example, the
rate increases on market-related credits could
outstrip the more slowly changing costs o f primerelated credit.
For these reasons, small firms without access to
the commercial paper market and larger firms with
less than flawless credit are likely to find primerelated loans attractive. Large, creditworthy firms,
furthermore, can be expected to continue to bargain
with banks for money market loans when interest
rates are falling rapidly, and to try to switch back
into prime-related loans when rates are rising or
are expected to remain unchanged.

The distinguishing feature o f the prime rate has
always been its stickiness in comparision with
money market interest rates. The prime has never
been closely related to any specific current short­
term rate, but instead has been priced as a markup
over banks’ cost o f raising new funds from all
sources. A substantial portion o f these funds have
been from deposits subject to interest rate ceilings,
and have been paid for by banks with implicit
interest in the form o f services. Because these

Brian C. Gendreau

implicit interest payments were difficult and slow
to adjust, banks’ cost o f funds, and hence their
loan rates, were slow to adjust to fluctuations in
market rates.
As interest rates became higher and more
volatile in the past fifteen years, the incentive for
customers to bypass banks and borrow and lend
directly in money markets strengthened. Banks
responded by issuing liabilities carrying market
rates o f interest to finance their loans, by speeding
up changes in the prime rate, and by offering
customers loans with rates tied to the rates on
money market instruments. Much o f the belowprime lending in recent years occurred when the
rates on these money market loans fell below the
more slowly moving prime during a decline in
interest rates.
With the advent o f a large quantity o f belowprime lending, the prime no longer represents the
lowest rate at which banks are extending credit.
But prime-related lending is far from gone. Firms
without the credit standing or funding needs to tap
money markets are likely to receive prime-related
loans for some time in the future. And even those
firms with the ability to issue their own paper in
the market are likely to find prime-related loans
attractive when interest rates are unchanged or
As deposit rate ceilings are phased out and
demand and savings deposits are replaced by
banks’ new money market accounts, bank loan
rates will move more closely with market rates.
Banks and their customers are likely to find a
reference rate for the cost o f short-term credit like
the prime useful in the future, but it will probably
be a faster moving, more closely market-related
rate than today’ s prime.



Bankers’ formulas for pricing loans and economists’ models o f setting loan rates are often based on
regressions o f the prime on current and past money market rates. These regressions contain estimates o f the
average lag o f adjustment o f the prime rate to market rates. By estimating these regressions over different
periods and comparing the average lags, we can tell whether the speed o f adjustment o f the prime has
changed over time.
Changes in the source o f funds used to make loans in turn change the speed with which the prime adjusts to
market rates. Consider, for example the simple case o f banks that raise in any period t. a portion a o f their
loanable funds from liabilities by paying a market rate o f interest RCDt , and the rest (1 - a) from demand
deposits by paying im plicit interest in the form o f services at the rate RDD f . The banks will set their prime rate
PRt as a markup y over the weighted cost o f raising extra funds from both sources, as:

PRt = y + aRCDt + (\ -a )R D D t


0< y ,0< a < 1
If banks paid a competitive, market rate o f interest at all times on demand deposits, then RDDt = RCDt . and
the prime would be set simply as a markup on current market rates:

PR{ = y + RCDt

Banks, however, generally adjust the services they pay on demand deposits incom pletely to changes in
current market rates. The inability to adjust services quickly, uncertainty about whether market rate changes
are permanent or transitory, and avoidance o f interest rate risk will all contribute to a gradual adjustment o f
im plicit interest rates to market rates. Assuming for expository purposes that all adjustment takes place
within two periods, this process can be represented as:

RDDt = p j RCDt + P 2 RCDt_j

° <P l , P 2< 1
Substituting equation (3) into equation (1) gives an expression for the prime as a function o f current and past
market rates:

PRt = y + 9 j RCDt + d2 RCDt j


6 j = ( a + /3j — a/3j )


#2 = ( P 2 ~ a ^2 )•

In equation (4) it is easy to see that as the proportion o f funds from interest-sensitive liabilities a increases,
current rates will get a larger weight in setting the prime. If all bank funds are interest sensitive (a = 1), the
prime rate will be a markup over current rates alone. If instead banks attract all their funds from demand
deposits (a = 0), the prime rate will be a markup o f the relation o f im plicit interest rates to market rates as given
in equation (3). Changes in the sources o f bank funds should be reflected in different coefficien t estimates
over time in a regression o f the prime against current and past market rates as specified in equation (4).

Adjustment Lag Estimates. To measure the changes in the adjustment lag o f the prime to market
rates, the prime was regressed against a distributed lag o f current and past 3-month CD rates, using weekly
data for each o f the four three-year periods between Novem ber 4,1970 and September 29, 1982. The 3-month
CD rate was taken to be representative o f rates on banks’ interest-sensitive liabilities. A geom etrically
declining pattern o f weights extending indefinitely into the past was specified for each regression, under the
assumption that banks place progressively less weight on market rates further in the past in setting the

prime .3 (Reasonable values o f a and the / j coefficien ts in a regression o f equation (4) with lags extending
further into the past will produce a geometric lag distribution like the one used here in estimation.)
The estimated weights on the current and past CD rates from the regressions are shown in the figure below.
The estimated average lag in adjustment o f the prime rate to changes in CD rates has changed significantly
over the four periods, and has generally been getting shorter over time, as can be seen in the table. By these
estimates, the prime was adjusted twice as fast over the 10/10/79 to 9/29/82 period as it was between 11/4/70
and 10/24/73. This quicker adjustment speed is reflected in the visibly steeper pattern o f estimated weights in
the figure below, indicating that banks have placed heavier weights on current and recent weeks’ CD rates in
setting the prime in more recent years.b
Mean Lag in Adjustment o f Prime
To CD Rate Changes (in weeks)

- 10/24/73
- 10/23/76
- 10/03/79
- 09/29/82


aThe weights were estimated by applying a Koyck transformation to the geometric distributed lag relationship, re­
gressing the prime rate on the prime rate lagged one week and the current week's CD rate. For a discussion o f the estimation
o f geometric distributed lag models, see Jan Kmenta, Elements o f Econometrics (New York: Macmillan, 1971), pp. 474475.
^For an alternative interpretation o f regression o f the prime rate on a distributed lag o f current and past CD rates, in
which the prime rate reflects the cost o f previously issued but still outstanding CD’s as well as current CD rates, see Michael
A. Goldberg, “The Pricing of the Prime Rate,” Journal o f Banking and Finance. 6 (June, 1982), pp. 277-296. In Goldberg’s study
the prime rate is linked to banks’ average cost o f funds, rather than their marginal cost o f raising funds from all sources as
described in the article.

W eight

WEEK (0 = current week)
W eights are from regressions o f the prime rate on an infinite geometric distributed lag o f current and past
3-month CD rates.

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