CUNA Regulatory Comment Call


June 19, 2002

Replacement of Discount Window Programs with Market-Rate Lending

EXECUTIVE SUMMARY

The Board of Governors of the Federal Reserve (Federal Reserve) requests comments on its proposal to replace its existing discount window programs namely the adjustment and extended credit programs with new programs called primary credit and secondary credit. Comments on this proposal are due to the Federal Reserve by August 22, 2001. The key features of these two programs are listed below:

Please send your comments to CUNA by August 2. Please feel free to fax your responses to CUNA at 202-638-7052; e-mail them to Associate General Counsel Mary Dunn at mdunn@cuna.com or to Assistant General Counsel Michelle Profit at mprofit@cuna.com; or mail them to Mary or Michelle c/o CUNA’s Regulatory Advocacy Department, 601 Pennsylvania Avenue, NW, South Bldg., Suite 600, Washington, DC 20004. For a copy of this proposal, which was published in the Federal Register on May 24th, please press here.

BACKGROUND

Currently, under Regulation A the Reserve Banks make credit available to depository institutions at the discount window by making advances secured by acceptable collateral. This Reserve Bank credit usually takes the form of an advance.

Reserve Banks presently make credit available at the discount window through three credit programs: adjustment credit, seasonal credit, and extended credit. Adjustment credit is available for short periods of time at a basic discount rate that typically has been 25 to 50 basis points below the market rates that apply to overnight loans as measured by the Federal Funds Rate. Reserve Banks also extend seasonal credit for longer periods than permitted under the adjustment credit program to help smaller depository institutions meet funding needs that result from expected patterns in their deposits and loans. Finally, Reserve Banks may provide extended credit to depository institutions where similar assistance is not reasonably available from other sources. The Federal Reserve System has relied on extended credit to aid depository institutions experiencing significant financial difficulties. The rates applied to seasonal and extended credit are at or above the basic discount rate set for adjustment credit.

In the adjustment credit program, the below market interest rates have created an incentive for financial institutions to take advantage of the spread. As a result, in order to curtail these incentives the Federal Reserve has had to place restrictions on the lending program. For example, Regulation A currently provides that a Reserve Bank cannot extend adjustment credit to a depository institution until the institution exhausts other sources of funds. Regulation A also prohibits the use of adjustment credit to finance sales of federal funds.

Moreover, these restrictions create cumbersome administration for Reserve Banks, which oversee adjustment credit. In particular, the Reserve Banks may need to review each prospective borrower's funding situation to establish that the borrower has exhausted other available sources of funds and that the reason for borrowing is appropriate. According to the Federal Reserve, the subjective nature of these determinations makes it had to keep the administration of the lending program consistent across the entire Federal Reserve System.

The Federal Reserve believes that administration of and restrictions on discount window credit create a burden on depository institutions that reduces their willingness to seek credit at the discount window. The Federal Reserve states that depository institutions often have cited uncertainty about their borrowing privileges as a disincentive to seek credit at the discount window. According to the Federal Reserve, “this reluctance” limits the effectiveness of the discount window.

The Federal Reserve believes that the interests of depository institutions, the Federal Reserve System, and the economy would be served more effectively by an above-market lending program in light of the issues mentioned above.

PROPOSED RULE

The Federal Reserve proposes to replace adjustment credit with a new lending program called primary credit and the extended credit program with a new program known as secondary credit. Although the proposed regulation retains the seasonal credit program with minor revisions, the Federal Reserve requests comment on whether a seasonal credit program remains necessary and, if so, whether the interest rate on seasonal credit would more appropriately be set at the primary discount rate. Comments will determine whether or not the seasonal credit program is retained and the rate for the seasonal credit program, if it is retained.

Primary Credit Program
Under the Federal Reserve's proposed rule, the primary credit program would replace the adjustment credit program, which presently offers below market interest rates. Primary credit would be extended on a very short-term basis (usually overnight) at an above-market rate, and ordinarily would be available to generally sound depository institutions with little or no administrative burden on the borrower or the Reserve Bank. A Reserve Bank also could extend primary credit with maturities up to a few weeks to a depository institution if the Reserve Bank finds that the institution is in sound condition and cannot obtain such credit in the market place on reasonable terms. The Federal Reserve expects that institutions receiving longer-term primary credit would be relatively small institutions that lack access to national money markets.

Although the primary credit program is designed to make short-term credit available as a backup source of liquidity to generally sound institutions, a Reserve Bank is not obligated to extend primary credit. A Reserve Bank may choose not to lend to a generally sound depository institution if the Reserve Bank determines that doing so would be inconsistent with the purposes of the primary credit program.

The interest rate on primary credit would be above short-term market interest rates, including the target federal funds rate, and would be set by the boards of directors of the Reserve Banks subject to review and determination by the Federal Reserve. The Federal Reserve proposes to recommend that the boards of directors of the Reserve Banks, subject to the Federal Reserve's review and determination, initially establish a primary discount rate that is 100 basis points above the prevailing target for the federal funds rate. According to the Federal Reserve, a spread of 100 basis points would be similar to the spreads employed by other central banks and likely would place the primary discount rate somewhat above the alternative cost of overnight funds for eligible depository institutions.

After establishment of the initial primary discount rate, the Federal Reserve System would change that rate through a process identical to the existing procedure for changing the basic discount rate. The boards of directors of the Federal Reserve Banks would establish a primary discount rate and other discount rates every two weeks subject to review and determination by the Federal Reserve, as required by the Federal Reserve Act. The primary discount rate presumably would move broadly in line with the target federal funds rate, much as the basic discount rate does currently.

The Reserve Bank would determine which financial institutions are sound enough to be eligible for primary credit. Reserve Banks would classify depository institutions with borrowing agreements already on file as either eligible or ineligible for primary credit before the program takes effect and would notify each institution of its status. A new applicant for Federal Reserve credit would be notified of its eligibility after filing borrowing documents with the appropriate Reserve Bank. The Reserve Banks would notify an institution promptly of any change in the institution's eligibility status. An institution's eligibility status, which would be based in part on that institution's confidential supervisory and examination information, would be considered confidential information.

The Federal Reserve expects that the Reserve Banks would enact uniform guidelines for determining an institution's financial soundness and, in turn, its eligibility for primary credit. The Federal Reserve envisions that the guidelines for determining eligibility would be based primarily on supervisory ratings, but supplementary information, such as ratings issued by major rating agencies, spreads on subordinated debt, and information from supervisory exams in progress also would be considered. The Federal Reserve further expects that the majority of depository institutions would be eligible for the primary credit program under such guidelines.

The Federal Reserve anticipates that Reserve Banks initially would adopt guidelines under which domestically chartered depository institutions with composite CAMELS ratings of 1 or 2 would be eligible for primary credit, unless supplementary information suggested that the financial condition of the depository institution had deteriorated since the most recent exam. Similarly, the Federal Reserve expects that institutions rated CAMELS 3 would be eligible for primary credit if supplementary information suggested that they were generally sound. However, the funding situation of such institutions seeking credit would be reviewed and monitored more closely than that of stronger institutions. The Federal Reserve expects that institutions rated CAMELS 4 would be ineligible for primary credit except in rare circumstances, such as an ongoing examination that indicated a substantial improvement in condition. The Federal Reserve further anticipates that institutions rated CAMELS 5 would not be eligible for primary credit and could obtain only secondary credit.

A depository institution that meets the eligibility criteria adopted by the Reserve Banks would not be required to exhaust other reasonably available sources of funds before obtaining primary credit. In addition, depository institutions that receive primary credit would be free to sell federal funds to others. The Federal Reserve would encourage financially sound institutions to use primary credit to fund sales of federal funds if such transactions were in their financial interest.

The proposal to adopt a primary credit program also is an aspect of the Federal Reserve's ongoing planning for contingencies. The Federal Reserve System expects to establish special procedures through which the System could lower discount rates quickly in an emergency. If the availability of primary credit significantly reduces the reluctance of depository institutions to use the discount window, then depository institutions will see it as a feasible lending alternative. Therefore the Federal Reserve System should be able to use the primary discount rate to set an upper limit on the federal funds rate during a crisis. For example, the Federal Reserve could set the primary discount rate to a level close to the federal funds target rate. As a result, institutions would not borrow at the federal funds rate if it were too high because they could borrow at the primary discount rate. In this manner, the Federal Reserve would be able to set an upper limit on the federal funds rate during a crisis.

In addition, the Federal Reserve expects that moving to an above-market primary credit program would be beneficial to the Federal Reserve System. For example, if Congress authorizes the Reserve Banks to pay interest on reserve balances, an above-market-lending program would allow the Reserve Banks to avoid lending to depository institutions at a below-market rate while paying interest to those institutions at a market-related rate. Also, if the level of required operating balances resumes the substantial downward decline experienced for much of the last decade, a lending program with appreciably less administration could enhance the day-to-day implementation of monetary policy. A decline in operating balances could lead to increased volatility in the federal funds rate, and the availability of reserves from an above- market lending facility would serve to limit the increase in volatility.

Secondary Credit
Secondary credit would replace extended credit and would be available to depository institutions that do not qualify for primary credit. The text of the proposed regulation seeks to eliminate the focus on longer-term credit extensions in the existing extended credit program and to broaden the types of borrowing situations that a Reserve Bank may handle under the secondary credit program.

Under the proposal, Reserve Banks may extend secondary credit to meet temporary funding needs of an institution if such a credit extension would be consistent with the institution's timely return to a reliance on market funding sources. A Reserve Bank also may extend secondary credit if it determines that such credit would facilitate the orderly resolution of serious financial difficulties for the borrowing institution. When extending secondary credit to an undercapitalized or critically undercapitalized depository institution, a Reserve Bank also must observe special requirements. The interest rate on secondary credit would be set by formula 50 basis points above the primary discount rate. This higher rate reflects the less-sound condition of borrowers of secondary credit.

Seasonal Credit
The proposed rule makes only minor revisions to the existing seasonal credit provisions of Regulation A. The seasonal credit interest rate is based on short-term market rates, and historical interest rate relationships suggest that the rate for seasonal credit usually will be below the primary credit rate. The proposed rule, which discusses the rate applicable to seasonal credit, would not contain existing language requiring the seasonal credit rate to be at least as high as the primary credit rate. In addition, the Federal Reserve for some time has not required that a seasonal credit borrower demonstrate that it could not obtain similar assistance from special industry lenders, and the proposed rule accordingly deletes this requirement.

The seasonal credit program was designed to address the difficulties that relatively small financial institutions with seasonal funding needs faced because of a lack of access to the national money markets. Reserve Banks traditionally have extended seasonal credit to small institutions that demonstrated significant seasonal swings in their loans and deposits. According to the Federal Reserve, however, funding opportunities for smaller depository institutions appear to have expanded significantly over the past few decades as a result of deposit deregulation and the general development of financial markets.

QUESTIONS

  1. Do you believe that the Federal Reserve should replace the adjustment credit program, which has below-market interest rates, with the primary credit program, which has above-market interest rates? Please explain.
















  2. If you do not believe in this replacement of the adjustment credit program with primary credit program, then why is a below-market interest necessary?
















  3. Do you believe that the initial rate for primary credit should be set at 100 basis points above the federal funds rate? Please explain.
















    If not, what rate is more appropriate? The Federal Reserve requests comments on this initial rate and states that comments may affect their selection of the initial and subsequent primary credit rates.
















  4. Do you believe that the Federal Reserve should replace the extended credit program, with the secondary credit program? Why or why not?
















    In the past, the interest rate for the extended credit program has been at or above the basic discount rate, which was typically 25 to 50 basis points below the market. In its proposed replacement, the secondary credit program, the interest rate would be 50 basis points above the primary credit rate, which would be at the market value. Do you support the proposed interest rate for secondary credit? Why or why not?
















  5. Is there an alternative rate for secondary credit that you would propose? Please explain.
















  6. The Federal Reserve specifically solicits comments on whether small depository institutions still lack reasonable access to the funding market. Do you think they still lack access? According to the Federal Reserve, funding opportunities for smaller depository institutions appear to have expanded due to deposit deregulation and the general development of financial markets. Is that the case? Despite those factors, is there still a lack of access? The Federal Reserve will use this information to determine whether it should continue the seasonal credit program.
















  7. Do you believe that there is a need for the seasonal credit program and that the Federal Reserve should keep it? The Federal Reserve will review the comment it receives to determine whether to keep or eliminate this program.
















  8. Please explain the appropriate setting of the seasonal lending rate, particularly in view of the proposed establishment of a primary credit program with an above-market rate. Do you believe that the seasonal credit rate should be at, above, or below the market rate? Please check one and explain
    At market____ Above market ____ Below market______
















  9. Do you have any other comments on the proposal?
















Eric Richard • General Counsel • (202) 508-6742 • erichard@cuna.com
Mary Mitchell Dunn • SVP & Associate General Counsel • (202) 508-6736 • mdunn@cuna.com
Jeffrey Bloch • Assistant General Counsel • (202) 508-6732 • jbloch@cuna.com
Catherine Orr • Senior Regulatory Counsel • (202) 508-6743 • corr@cuna.com