XVI. Analyze the texts. Complete a list of advantages and disadvantages for the borrower of each of the types of credit.

 

Types of Credit

 

The three basic types of discount window credit are adjustment credit, seasonal credit, and extended credit.

· Adjustment credit helps depository institutions meet short-term liquidity needs. For example, an institution experiencing an unexpectedly large withdrawal of deposits may request ad­justment credit overnight or for a few days until it finds other sources of funding.

· Seasonal credit assists smaller institutions in managing liquid­ity needs that arise from regular, seasonal swings in loans and deposits, such as those at agricultural banks associated with the spring planting season.

· Extended credit may be provided to depositories experiencing somewhat longer-term liquidity needs that result from excep­tional circumstances.

In addition, the Federal Reserve has the power to extend emer­gency credit to entities other than banks, although it has not done so since the 1930s.

Adjustment Credit

Adjustment credit helps depository institutions meet temporary liquidity needs arising from short-term fluctuations in assets and liabilities. Three basic principles govern the provision of adjust­ment credit:

· The Federal Reserve Bank provides credit at its own discretion.

· Borrowing must be for an appropriate reason.

· The borrower must seek other reasonably available sources of funds before turning to the discount window.

No fixed rules define an appropriate reason for borrowing. Some common situations that are appropriate for borrowing include meeting liquidity needs arising from an unexpected loss of deposit or nondeposit funding, avoiding unexpected overnight overdrafts in the institution's reserve account, or meeting liquid­ity needs arising from operational problems beyond the institu­tion's control or from an external event such as a natural disaster.

Discount officers apply judgment also in determin­ing whether an institution has sought all other rea­sonably available sources of funds before turning to the window. For example, most large institu­tions are presumed to have greater access to alter­native funding sources than small community banks have. Branches and agencies of foreign banks, even if they are not large, are presumed to have access to funding in national markets and from their foreign parents or affiliates. Depositories that are mem­bers of multibank holding companies are expected to seek funding from affiliates before turning to the window. Institutions that have access to a special industry lender, such as the Federal Home Loan Bank System, are expected to use these sources before requesting an advance from the discount window.

When reviewing a borrowing request, discount officers consider other pertinent information at their disposal, such as information from the institution's primary supervisor, balance sheet informa­tion, the frequency and amount of past borrowing, and the institution's general management of its reserve account. While borrowing under the adjustment credit program, institutions pro­vide daily balance sheet data to the Federal Reserve for monitor­ing purposes. Discount officers carefully review these data to en­sure that adjustment credit is not being used inappropriately, such as to fund a planned increase in loans, securities, or federal funds sales or a predictable decline in deposit funding or other liabilities.

A significant factor that affects the level of adjustment borrowing is the spread between the federal funds rate and the discount rate. Partly because discount officers routinely monitor banks to ensure that borrowing requests are for appropri­ate reasons and partly because the market pays close attention to banks that might be relying on discount window credit, most banks are generally reluctant to borrow at the discount window. A positive spread between the federal funds rate and the discount rate (that is, a federal funds rate higher than the discount rate) provides a pecuniary inducement to borrow. When reserves are in heavy demand or short supply, the spread between the federal funds rate and the discount rate tends to widen, encouraging more institutions to overcome their reluctance to borrow. The re­sulting injection of borrowed reserves helps to alleviate reserve market pressures and to moderate any unexpected spikes in the federal funds rate. In this way, adjustment borrowing serves as a safety valve that relieves short-term pressures in the reserves market.

The level of adjustment borrowing has declined on balance since 1980. This trend reflects several factors. During a period in which many banks were failing, banks became concerned that the mar­ket might detect borrowing at the window and interpret it as a sign of financial weakness. Also, a relatively narrow spread be­tween the federal funds rate and the discount rate reduced the pecuniary incentive to borrow. Finally, various measures imple­mented by the Federal Reserve in recent years to reduce risk in the payments system have generally led depositories to monitor their reserve account positions more closely during the day and conse­quently they can more promptly respond to unexpected funding losses without relying on discount window credit. The downward trend in adjustment credit notwithstanding, the Federal Reserve encourages banks to turn to the window in appropriate circum­stances. Only in this way can the discount window continue to fulfill its role as a safety valve in the reserves market.

Adjustment borrowing and the spread of the federal funds rate over the discount rate

 

Seasonal Credit

Established in 1973, the seasonal credit program assists small in­stitutions that lack effective access to national money markets. To qualify for the program, an institution must demonstrate a sea­sonal funding need arising from regular, intra-yearly swings in deposits and loans that persist for at least four weeks. The pro­gram is structured so that larger institutions must meet a larger portion of their seasonal need through market funding sources-institutions with more than $250 million in total deposits generally cannot demonstrate a need under the criteria of the seasonal program. Also, institutions with access to a special industry lender that provides similar assistance are expected to use that source before using the Federal Reserve seasonal credit program. The regular pattern in seasonal borrowing during any given year is associated primarily with loan demand in the farm sector. Most seasonal borrowers are small agricultural banks that face strong loan demand and deposit runoffs during the planting and growing seasons over the spring and summer months. Later in the year, farmers reap their harvest and pay down their bank loans. Simultaneously, banks pay down their seasonal loans from the Federal Reserve.

 

Seasonal borrowing

 

 

The amount of seasonal borrowing grew rapidly from 1986 through 1989. Most of the growth re­flected increasing use of the program by non-member banks that had not been eligible for the program before the Monetary Control Act. In the early 1990s, the peak volume of seasonal borrowing edged down, probably because of somewhat weaker loan demand during a period of sluggish economic growth and the move to a market-related in­terest rate on seasonal credit.

Extended Credit

Extended credit may be provided when exceptional circum­stances or practices adversely affect an individual institution. To obtain extended credit, a borrower must comply with certain conditions: It must make full use of reasonably available alterna­tive sources of funds and have a plan in place for eliminating its liquidity problems. The institution must report special data on its financial condition, including data on its lending, which may be restricted while it is borrowing from the Federal Reserve. The Federal Reserve extends credit of this type in coordination with the borrower's primary supervisor.

When conditions warrant, extended credit may be granted to in­stitutions experiencing difficulties adjusting to changing condi­tions in the money market. For example, during the period of high interest rates in the early 1980s, many thrift institutions suf­fered substantial losses of deposits. In cooperation with the Fed­eral Home Loan Bank System and other supervisors, the Federal Reserve provided temporary assistance to some thrift institutions until they could obtain funding elsewhere or make other adjust­ments to their balance sheets.

In determining whether to lend under the extended credit pro­gram, the Federal Reserve has always reviewed the financial condition of an institution. The Federal Reserve has sometimes pro­vided credit to troubled depositories to facilitate an orderly clo­sure of the institution. In the 1980s, faced with a succession of banking crises and record numbers of bank and thrift institution failures, the Federal Reserve, in cooperation with other regula­tors, extended a significant volume of credit to troubled institu­tions until the problem could be resolved in an orderly fashion.

In the early 1990s, Congress began seeking ways to speed the resolution of troubled institutions in an effort to reduce the cost of bank and thrift institution failures. The outcome of this process was the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). The "prompt corrective action" provisions of FDICIA place increasingly severe restrictions on depositories as their capital positions deteriorate and creates a framework that expedites the resolution of depositories that are close to insolvency.

Among the restrictions imposed by FDICIA on depositories in weak capital condition are limitations on access to the Federal Reserve's discount window. Since December 1993, FDICIA has limited the availability of Federal Reserve credit for undercapital­ized and critically undercapitalized institutions. FDICIA stipu­lates that the Federal Reserve may not lend to an undercapitalized institution for more than 60 days in any 120-day period without incurring a potential liability to the FDIC; exceptions to this rule arise if the borrower's primary federal supervisor certifies that the institution is viable or if the Board conducts its own examination of the borrower and certifies that it is viable. A viable institution is one that is not critically undercapitalized, is not expected to be­come critically undercapitalized, and is not expected to be placed in conservatorship or receivership. FDICIA states that the Federal Reserve may not lend to a critically undercapitalized institution for more than five days beyond the date on which it became criti­cally undercapitalized without incurring a potential liability to the FDIC and must report any liability of this nature to Congress within six months after it is incurred.

Emergency Credit

Section 13 of the Federal Reserve Act empowers the Federal Re­serve to lend to individuals, partnerships, and corporations un­der "unusual and exigent" circumstances. When not secured by U.S. government securities, any loans to nondepositories under this authority must be approved by five members of the Board of Governors. Lending under these provisions has been extremely rare, and such loans have not been extended since the 1930s.

 

Unit VI

The USA commercial banking

Market structure

 

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