Anna J. Schwartz Anna J. Schwartz is a Senior Research Fellow at The National Bureau of Economic Research. This paper was the sixth annu- al Homer Jones Memorial Lecture, which was presented at St Louis University on April 9, 1992. The views expressed are those of the author and do not reflect official positions of the Board of Governors of the Federal Reserve System or the Fed- eral Reserve Bank of St. Louis. The Homer Jones Memorial Lecture is an annual event sponsored by the St. Louis Gateway Chapter of the National Association of Business Economists in conjunction with Washington University St. Louis University, the University of Missouri-St. Louis and the Federal Reserve Bank of St. Louis. Author’s note: For sharing his knowledge of Federal Reserve practices, Walker F Todd has been immensely helpful to me, but he is not responsible for the views I express in this paper I have also benefited from comments by Allan H. Meltzer The Misuse of the Fed’s Discount Window U it AM HONORED to have the opportunity to the 259 national member banks that had failed give the Homer Jones Memorial Lecture. In since 1920 had been “habitual borrowers” prior remembering him today, I pay tribute to his to their failure. Of 457 continuous borrowers in contributions to monetary policy making and to 1926, 41 banks suspended operations in 1927, quantitative monetary research in his capacity while 24 liquidated voluntarily or merged (Shull as director of research at the St. Louis Fed. I 1971, 34-35). got to know Homer during the period of his membership in the Shadow Open Market Com- The reason for citing these statistics for the mittee. At our meetings he was diffident about 1920s is to call attention to an early episode in his knowledge and insistent on scrupulous at- Federal Reserve history that contravened the tention to statistical evidence as backing for the ancient injunction to central banks to lend only policy conclusions we reached. I cannot think of to illiquid banks, not to insolvent ones, and that two more admirable qualities in an economist. It is eerily similar to a current episode. The Fed was a privilege for me to have had this associa- apparently learned little from the earlier epi- tion with Homer. sode, since there is even less justification for the use made of the discount window in the In 1925 the Federal Reserve Board collected current t.han in the earlier episode. data on the number of member banks continu- ously indebted to their Reserve Banks for at The current episode came to light after the least a year. As of August 31, 1925, 593 mem- House Banking Committee requested data on all ber banks had been borrowing for a year or insured depository institutions that borrowed more. Of this number, 239 had been borrowing funds from the discount window from January since 1920 and 122 had begun borrowing before 1, 1985, through May 10, 1991. Regulators that. The Fed guessed that at least 80 percent of grade banks on their performance, according to a scale of I to S. The grades are based on five failed, since CAMEL ratings did not then exist. measures known by the acronym of CAMEL, Currently, CAMEL ratings 4 and 5 are known for Capital adequacy, Asset quality, Manage- promptly. Why should it be impossible or even ment, Earnings, Liquidity) The Federal Reserve difficult to distinguish between an illiquid and reported that of 530 borrowers from 1985 on an insolvent bank? that failed within three years of the onset of Support by the Fed for banks with a high their borrowings, 437 were classified as most probability of insolvency in the near term is not problem-ridden with a CAMEL rating of 5, the the poorest rating; 51 borrowers had the next only recurrent problem with the discount window. Equally troublesome is the history of lowest rating, CAMEL 4. One borrower with a actual or proposed Fed capital loans to non- CAMEL rating of 5 remained open for as long as 56 months. The whole class of CAMEL banks. Such use of the discount window dis- tracts the Fed’s attention from its monetary 5-rated institutions were allowed to continue control function. Recent experience reinforces operations for a mean period of about one year. earlier doubts about the need for the discount At the time of failure, 60 percent of the bor- window. The time has come for a truly basic rowers had outstanding discount window loans. change: eliminate the discount window and re- These loans were granted almost daily to insti- trict the Fed to open market operations.2 This tutions with a high probability of insolvency in change would have the added value of obliterat- the near term, new borrowings rolling over ing the symbolic role of the discount rate and balances due. In aggregate, the loans of this weakening the tendency to regard the Fed as group at the time of failure amounted to $8.3 determining interest rates. billion, of which $7.9 billion was extended when In the rest of this paper, I document the ero- the institutions were operating with a CAMEL 5 sion of the historic restriction, at least since the rating. Three months prior to failure, borrow- ings of all 530 institutions peaked at $18.1 bil- 1930s, of Federal Reserve discount window assis- tance to liquidity-strained banks on the security lion. Rather than encouraging banks to pursue of sound assets. Section 1 deals with lending strategies to preserve their size, regulators often encourage institutions that are about to fail to operations from the founding until the post- World War II period, during which loans to shrink drastically first, so as to diminish the pool of assets that have to be liquidated after nonbanks first occur. I then discuss Federal Reserve actions in recent decades that have fur- closing. ther blurred the distinction between liquidity Some observers of bank performance have as- and solvency, and also the emergence of various serted that it is impossible to know whether an nonbanks as candidates for discount window as- institution that applies for discount window as- sistance. I ask why these developments have oc- sistance faces a liquidity or solvency problem. curred when there has been no change in official That assertion may be defensible for discount declarations of commitment to supply only li- window lending in the 1920s even though an quidity, not solvency or capital, to individual estimated 80 percent of long-time borrowers banks, not nonbanks (section 2). In the next sec- ‘Brief official descriptions of composite CAMEL 4 and 5 rat- changes would eliminate the problem of political pressures ings follow: on the Fed to lend to nonbanks. As for the problem of CAMEL 4 “Institutions in this group have an immoder- loans to insolvent banks, access to the window as a right ate volume of serious financial weaknesses or a combi- at a penalty rate might only result in worsening adverse nation of other conditions that are unsatisfactory. Major selection. and serious problems or unsafe and unsound conditions See also Kaufman (1991), who argues that the discount may exist which are not being satisfactorily addressed or window is not needed to protect the money supply — the resolved.” basic justification for a lender of last resort — and that li- CAMEL 5 “This category is reserved for institutions quidity strains can be mitigated by open market operations with an extremely high immediate or near-term probability without involving the Fed in discount window assistance. of failure.” Credit-worthy banks can borrow at market rates, large ones CAMEL ratings of banks are not uniform from one district in the Fed Funds market, small ones from their correspon- to another. Some New York CAMEL 4 banks may be rated dent banks. 5 elsewhere. 2This recommendation has been disputed on the ground that establishing access to the discount window as a right — not a privilege — administered at a penalty rate would solve the problems that face the current administration of the window. It is not clear to me, however, that these tion I examine the costs of Federal Reserve sup- appears in an internal Federal Reserve history port for problem institutions that regulatory of the discount mechanism: “extended borrow- authorities eventually close and for nonhanks ings by a member bank from its Reserve Bank that would otherwise have to meet a market would in effect constitute a use of Federal test (section 3). Finally, I consider whether re- Reserve credit as a substitute for the member’s forms of discount window practices that have capital” (Hackley 1973, 194). The 1973 version been proposed could remedy the inherent of Regulation A states, as a general principle, problems of the mechanism. I comment on pro- that “Federal Reserve credit is not a substitute visions in the FDIC Improvement Act of 1991 for capital and ordinarily is not available for ex- that may be worthy reform proposals but do tended periods.” Both the 1980 and 1990 ver- not address these problems (section 4). 1 offer sions of Regulation A state, as a general require- my conclusions in section 5. ment, that “Federal Reserve credit is not a sub- stitute for capital.” A broader statement of the foregoing princi- ple, covering banks and nonbanks, appeared in 1932 in a conference report by representatives of the Federal Reserve Bank of New York, who had met with South American central banks: Regulation A—the first one adopted by the “Central banks must not in any way supply cap- Federal Reserve Board at its creation, in recogni- ital on a permanent basis either to member tion of the expectation that the discount window banks or to the public, which may lack it for at Federal Reserve Banks would serve as the the conduct of their business” (Federal Reserve main purveyor of member bank reserves— Bulletin 1932, 43).