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Fed To Charge Banks More To Borrow

The Federal Reserve on Friday unveiled a significant shift in its operations as the nation's lender of last resort. It proposed making it more expensive for banks to borrow directly from the Fed.

Currently, banks that go to the Fed's discount window are able to get loans that are about a half percentage point below the Fed's target for the federal funds rate, the interest that commercial banks charge each other for loans.

Under the proposal, the Fed would take away that break and instead charge banks using the discount window 1 full percentage point higher rate than the funds rate. If the change is adopted after a public comment period, it would be the most significant change in the Fed's discount window operations in nearly two decades.

The banking industry was caught by surprise by the Fed proposal but some officials said it might increase flexibility in Fed operations, especially during times of high demand for bank reserves such as occurred after the Sept. 11 terrorist attacks. They said it not immediately clear what impact it would have on consumer interest rates.

They noted that the volume of Fed lending from the discount window is small, but for banks facing difficulty raising reserves, the Fed's loan window can be crucial.

"This is a major departure from current policy. We will as an industry have to evaluate it very carefully," said Keith Leggett, senior economist at the American Bankers Association.

Some bank economists wondered about the timing of the Fed proposal.

"This is awkward timing given that the economic recovery is just getting under way," said Carl Tannenbaum, chief economist at LaSalle Bank/ABN Amro in Chicago. "We have enough credit stresses out there already."

Currently, the funds rate target is 1.75 percent, the lowest level in 40 years, and the discount rate is 1.25 percent.

The Fed said it was proposing the change to cut down on administrative costs of screening banks that seek loans directly from the Fed. Because the discount rate is lower than what banks can receive if they borrow from each other on the open market, the Fed monitors to make sure banks are not abusing their access to the discount window as a way to get cheaper money.

By proposing this change to a higher rate for discount window borrowing, the Fed would remove the financial incentive for banks to try to obtain loans from the central bank.

Throughout the Fed's history, the discount window has served as the bank's primary way of serving as a lender of last resort, helping financial institutions obtain the reserves they needed to keep operating during periods when they were short on resources.

Usually, the discount window helps banks keep operating until they get fresh reserves through normal operations. Sometimes, however, the discount window borrowing is used by federal regulators to keep bankrupt institutions functioning until they can be shut down and their operations taken over by a healthy bank.

Fed officials said the proposed switch to a higher interest rate charge would not eliminate the Fed's function as a lender of last resort. In fact, the Fed proposed creating a second rate level for banks having trouble obtaining short-term loans from other banks that would be 1.5 percentage points higher than the funds rate.

Officials said the revised higher rate structure would bring Fed practices more into line with the practices of other central banks around the world.

It would mark the biggest change in Fed borrowing operations in about two decades, since Congress in the early 1980s opened the Fed's discount window to all financial institutions, not just banks who are members of the Federal Reserve system.

On a typical day, the Fed has about $100 million in loans outstanding from the discount window. However, direct borrowing from the Fed can spike dramatically during periods of crisis. It hit record levels in the days following the Sept. 11 terrorist attack, when the Fed let it be known that it stood ready to make whatever loans were needed to keep the nation's financial system operating.

The Fed proposal, which the Fed put out for public comment on Friday, could be revised before the central banks decides whether to implement the proposed changes.

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