Making Sense of the Federal Reserve

Discount Window Lending

Good morning. I would like to withdraw $1,000 from my account.

OK. Here you are.
This is a promissory note another of our customers signed when he borrowed money from us to buy a car. In this loan contract, he states he will pay back $1,000. Of course, that means that this note is worth $1,000.

Wait a minute! This is no good to me. I can't spend this right now. This isn't liquid. It will take too long to convert this into cash and I need cash!

Discount Window Lending

It's late afternoon, and Flanders Community Bank is short on the available cash it is required to hold in reserves. It has plenty of assets, such as loans it has made to customers for cars, homes, or education. However, it must have the required cash in case its customers come to the bank to make withdrawals. For example, consider what might happen if a customer came in for a $1,000 withdrawal and, instead of cash, the teller offered the customer a different customer's car loan.

The conversation might go like the scenario to the left.

It's important that Flanders Community Bank not be caught short on cash because it cannot pay its customers in other people's loans and other nonliquid assets. However, what happens when it's late in the day and too late to arrange an overnight loan from a fellow bank? How will this bank get the cash it needs? Flanders has another option: It can borrow the cash from the Federal Reserve.

One of the most important ways that the Fed provides liquidity to the banking system is by offering funds for loans through its discount window. Traditionally, banks would come to the discount window for loans only when they could not borrow from any other institution.

Next: Term Auction Facility »