New York Fed newspaper challenges discount window stigma From Reuters

Michael S. Derby

NEW YORK (Reuters) – Banks that are most reluctant to use the U.S. central bank’s discount window to shore up their capital actually face the highest risk of failure, according to a new New York Federal Reserve study that redefines the concept of a bank. The stigma of emergency lending is turned on its head.

The stigma at issue is the long-held belief that when a bank borrows from the Fed’s long-term emergency lending discount window, others will perceive it as being in trouble and get into trouble as a result. To avoid such perceptions, banks will instead avoid the Fed, which in turn increases the risk that affected banks could end up in even deeper trouble.

Concerns about stigma have long plagued central bankers, who have encouraged banks to use the discount window without fear. Even so, in the spring of 2023, amid a rapidly developing banking panic, the Fed created an entirely new line of credit to ensure banks could borrow without fear, a clear acknowledgment that stigma risks remained an issue.

A document from the Federal Reserve Bank of New York, which was posted on the regional Fed bank website on Thursday, argued that, based on borrowing costs, there appears to be a stigma attached to troubled banks that avoid borrowing within the discount window compared to those who take loans from the Federal Reserve.

“We believe that the stigma is persistent and caused by the financial weakness of the bank,” the study authors write. “Our results suggest that stigma is more informative of bank failure risk than borrowing (discount window), both in normal times and when financial markets are under stress.”

“The probability of failure among (discount window) borrowers was actually lower than the probability of (unconditional) failure among all banks,” the paper said.

The study measured stigma as a function of borrowing costs. Among the institutions where stigma problems are greatest, for banks with assets under $50 billion, higher private market borrowing rates cost these firms a combined $500 million in excess interest costs relative to where they could have borrowed the money at the Fed for the decade ending in 2024. .

The paper notes that banks willing to borrow from the Fed should be rewarded because it makes them stronger than those that don’t. “Our results suggest that the opposite of stigma should occur: rather than being stigmatized, the (discount window) borrower should be given favorable terms because they are less likely to fail than the average bank,” the researchers wrote.

U.S. central bankers are trying to make sure all banks are willing to use the discount window, even though using the mechanism would not signal to regulators that affected institutions are in trouble.