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short essays and reports on the economic issues of the day
2008 ■ Number 27

Walter Bagehot, the Discount Window, and TAF
Daniel L. Thornton, Vice President and Economic Adviser
widely recognized critical function of a central bank
minimum bid rate; however, all loans are made at the lowis to be a lender of last resort, particularly in times
est rate (the stop-out rate) that exhausts the amount of funds
of financial distress. Walter Bagehot—a 19th century
being auctioned. The initial auction was for $20 billion;
English intellectual—summarized the lender of last resort
the most recent auction was $150 billion.
function with the dictum “lend freely at a high rate, on good
collateral.” In response to the mortgage-related distress in
“Lend freely at a high rate,
financial markets, the Fed has implemented a number of
on good collateral.”
new lending programs. Prominent among these is the
—Walter Bagehot
Term Auction Facility (TAF), through which the Federal
Reserve Banks auction funds to depository institutions.
The TAF may not reflect Bagehot’s views on the role of a
By contrast, discount window loans are initiated by
lender of last resort—and neither may recent traditional
depository institutions that come to the Fed and request a
discount window lending.
loan. Discount window loans adhered to Bagehot’s dicSince the Fed’s inception, banks have been allowed to
tum—lend at a high rate—in that the primary credit rate
borrow from Reserve Banks’ discount windows. Once an
was set at 100 basis points above the Federal Open Market
Committee’s target for the federal funds rate. But under
important source of bank reserves, borrowing at the discount
the TAF, depository institutions compete for funds by
window has diminished over time: After substantial borrowindicating the amount they wish to borrow and the rate
ing by then-troubled Continental Illinois Bank in early 1984,
depository institutions became more reluctant to borrow
that they are willing to pay.
from the Fed and borrowing fell
to tertiary levels. Consequently,
few depository institutions borFigure 1
Funds Target, Primary Credit Rate, 1-Month CD Rate, 1-Month Eurodollar Rate,
rowed from the discount window
and TAF Stop-Out Rate
during the early months of the
financial market turmoil in 2007.
To provide more liquidity to
depository institutions (and with
the hope of reducing their reluctance to borrow at the discount
window), on December 12, 2007,
the Fed announced the establishment of a temporary Term
Auction Facility. Under the TAF,
the Fed supplies a predetermined
amount of funds to depository
Primary Credit Rate
TAF Stop-Out Rate
institutions for 28-day (two main1-Month CD Rate
tenance periods) and 84-day
1-Month Eurodollar Rate
terms against the same collateral
Funds Target
used to secure conventional dis0.0
count window loans. The funds
are auctioned. The Fed sets a


Economic SYNOPSES

Federal Reserve Bank of St. Louis


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Figure 1 shows the primary
credit rate, the 1-month CD and
Figure 2
Primary Credit Outstanding and the Spread Between the Primary Credit Rate
eurodollar rates, and the stop-out
and the 1-month CD Rate (daily averages of weekly figures for weeks ending the date shown)
rates for each of the 24 TAF aucBillions of Dollars
tions: The stop-out rate has been
at or below CD and eurodollar
rates and often below the primary
credit rate. Hence, rather than
lending at a penalty as Bagehot
recommended, the TAF has pro0.0
vided funds at rates that have gen–0.5
erally been low relative to rates
that depository institutions would
have had to pay otherwise. Indeed,
the rate on the $150 billion aucPrimary Credit (left scale)
Spread (right scale)
tion held on October 6 was 1.39
percent, 86 basis points below
the then primary credit rate of
2.25 percent and 36 basis points
below the new primary credit
rate of 1.75 percent established
on October 8.
The figure also shows that until recently the primary
and the average daily percentage point difference between
credit rate was a penalty rate relative to rates on CDs or
the primary credit rate and the 1-month CD rate for the
eurodollars. The primary credit rate remained a penalty rate
same weeks (right scale). The primary credit rate is a penalty
despite the Fed reducing the spread between it and the funds
rate when the difference is positive and a subsidy rate when
rate target from 100 to 50 basis points on August 17, 2007.
it is negative. The figure suggests that the reluctance by
On March 18, 2008, the Fed reduced the spread further to
depository institutions to borrow from the Fed—which
just 25 basis points. On the next day, the Fed reduced the
had characterized discount window borrowing since midprimary credit rate 75 basis points by reducing the funds
1984—appears to have vanished. Indeed, primary credit
rate target by that amount. As a result of these actions, the
has recently been at levels not experienced historically at
primary credit rate has since been consistently lower than
the discount window. The strong negative correlation
the CD and eurodollar rates.
(–0.84) between these series suggests that depository instiFigure 2 shows the average daily level of primary credit
tutions borrow primarily when the primary credit rate is a
outstanding for weeks ending the date shown (left scale)
subsidy rate. ■

Views expressed do not necessarily reflect official positions of the Federal Reserve System.