What would happen to the economy if the Fed's discount window completely stopped?

Question

I'm curious what would happen the the US economy (and perhaps others) if the overnight lending capability of the Fed ceased operation for some reason (perhaps a cyber attack) for a non-trivial period of time (a week or more). What are the possible implications of that? Would there be panic, massive loan defaults, lack of operating capital or other nasty things? Also, for the sake of argument, that we didn't know how long the overnight lending capability of the Fed would be down and only speculated at the reason. Would banks just weather the storm for a week or so, or would thing get ugly?

Answer 1

First, one note on the premise. The Fed basically operates a giant ledger for financial institutions, each of which has a certain balance in its "master account". Over $3 trillion is moved between accounts each day via Fedwire, and these accounts are also used for settling most traditional checks and ACH transactions, which include many of the everyday transactions in the economy. Even alternative payment networks not provided by the Fed, like CHIPS, ultimately use the Fed's ledger to clear net payments.

When the Fed loans money to banks via the discount window, it simply adds to their account balance on this ledger; many "cyberattacks" that disabled this capability would probably also disable the ledger itself. This would certainly mean chaos, but the missing discount window wouldn't be the most important aspect of this chaos - the real problem would be the breakdown of the economy's payment system.

That said, now suppose that somehow the discount window vanished but the Fed's other services continued. There wouldn't necessarily be any immediate consequences: as of the end of 2014, the Fed was lending very little via its discount window. The H.4.1 "factors affecting reserve balances" release shows that the total of "primary", "secondary", and "seasonal" credit provided to banks was virtually zero relative to the size of the banking system as a whole, at $112 million. This is because the discount rate, currently at 0.75%, is well above other short-term interest rates and has additional strings attached; it only makes sense for banks to borrow from it if they don't have good other options.

The real purpose of the discount window, of course, is to serve as the lender of last resort. And it has been used substantially in that capacity during times of crisis: for instance, in October 2008 there was $100 billion in discount window lending, 1000 times the current level. (Other, newer forms of Fed assistance to the non-bank financial system made the total level of Fed intervention much higher still.) In fact, the acute phase of the 2008 financial crisis for Goldman Sachs and Morgan Stanley, two large investment banks, ended when they became bank holding companies with full access to the Fed's discount window.

In general, if a crisis was already underway, I'm sure that a missing discount window could lead to panic. But without an ongoing crisis, I doubt the ramifications of a temporary discount window shutdown would be too severe: the promise of a restored discount window in a week or two would be enough to stem any speculative run, and banks have many options to deal with short-term funding needs in the interim. They are required, after all, to hold certain levels of liquidity, meaning a combination of reserves and securities that can quickly be sold or lent out for reserves.

By the way, if not only the discount window but also all other interventions into overnight money markets stopped, then in normal times there would also be chaos. Banks' demand for reserves is inelastic in the short-run and subject to shocks; and if the New York Fed was not elastically supplying reserves to keep the federal funds rate at the target, there would be massive volatility in short-term interest rates. (Volatility in the early 80s, when the Fed partly targeted monetary aggregates rather than interest rates - but still engaged in plenty of discretionary interest rate smoothing - gives a small taste of what this volatility would look like. Or we can look at how irregular rates were before the establishment of the Fed.) This would not be true today, however, because the banking system is awash in excess reserves.