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The Fed's 'discount window' saw a huge uptick in demand amid financial turmoil

ADRIAN FLORIDO, HOST:

Last month, the banking system found itself in deep trouble. Three U.S. banks went under, including, of course, Silicon Valley Bank. The Federal Reserve does have tools that are supposed to help banks in times like these. One of the oldest, most important tools is called the discount window. It's essentially a place where banks can go when they need a loan. Mary Childs of NPR's Planet Money is here to tell us a bit of the history behind the discount window. Hi, Mary.

MARY CHILDS, BYLINE: Hey, Adrian.

FLORIDO: OK. So the discount window - what exactly is it?

CHILDS: The discount window is actually part of the reason the Fed was created in the first place. In the early 1900s, there were all these bank runs. And one of America's richest guys, J. Pierpont Morgan, stepped in, organized a big bailout. And everyone was like, that seems like kind of a bad plan if our entire banking system just relies on the good graces of some rich guy. So in 1913, the Federal Reserve was born. And its most basic function is as the lender of last resort. If a bank is having a hard time, it could always come to the discount window, a literal window at the time, and it could get a loan from the Fed and live to lend another day.

FLORIDO: So it sounds like the discount window is basically a bank for banks. Tell me a little bit more about how that works.

CHILDS: So when a bank needs extra money, it can go to the window and hand over what's called collateral, any valuable thing that the Fed can sell if that bank doesn't end up being good for the money. And the bank gets the loan from the Fed. And at first, it was actually cheaper to borrow from the Fed at this window than from basically anybody else. And as a result, banks were borrowing from the window all the time, too much, relying on it, which kind of annoyed the Fed. They wanted to be the lender of last resort, not first resort. It's not really how an independent, privately run banking system is supposed to work.

FLORIDO: OK, so too many banks were relying on this discount window. And so what did the Fed do to try to address that?

CHILDS: They added some disincentives. They tried just telling the banks, hey; please stop. Don't use it so much. And that didn't really work. So at one point, they made it more expensive than other places where banks could borrow. And they tried this other way that ended up being super-effective. They said, OK, you can borrow from the window, but you have to ask everybody else for a loan first. And only if everyone else says no will we lend to you. And that requirement created a stigma. Here's Yesha Yadav, a professor at Vanderbilt University's Law School.

YESHA YADAV: Banks are super-reluctant to use the discount window. And sometimes, they're willing to take the long way round to avoid being caught in this walk of shame.

FLORIDO: OK. So, Mary, did banks then basically just stop using the discount window?

CHILDS: They tried, yeah. It was kind of a problem. They weren't using it when they needed it. So then the Fed had to go in the other direction and encourage banks to use it. They got rid of that requirement. And they workshopped a pretty brilliant hack basically borrowed from high school. They got the cool kids to do it. Here's Yadav again.

YADAV: What happened was that to get folks to take the loan, they got the big banks to all borrow from the discount window to ease that sense of stigma and shame because it felt like, the big banks are doing it. So can we.

CHILDS: That's really funny. Peer pressure is so powerful.

YADAV: Peer pressure is so powerful, especially with the big cats.

CHILDS: So in the 2020 recession sparked by the onset of COVID, the Fed encouraged the big banks to borrow from the discount window and then tell everybody that they'd done so. And that broke the stigma. It loosened up borrowing. And in our most recent bank freakout, banks used the window. In one week, bank borrowings from the discount window went from $5 billion to a record $153 billion.

FLORIDO: Wow. OK. That was Mary Childs of NPR's Planet Money. Thanks, Mary.

CHILDS: Thank you. Transcript provided by NPR, Copyright NPR.

Mary Childs (she/her) is a co-host and correspondent for NPR's Planet Money podcast. Before joining the team in 2019, she was a senior reporter at Barron's magazine, where she covered the alternatives industry, the bond market and capitalism. Before that, she worked at the Financial Times and Bloomberg News. She's written about the pioneering of new asset classes like time, billionaire's proposals to solve inequality and diversity and discrimination in the finance industry. Before all that, she was also a Watson Fellow, spending a year traveling the world painting portraits. She graduated from Washington & Lee University in Lexington, Virginia, with a degree in business journalism and an honors thesis comparing the use and significance of media sting operations in the U.S. and India.