Adjustment Credit

Types of Credit

XVI. Analyze the texts. Complete a list of advantages and disadvantages for the borrower of each of the types of credit.

The three basic types of discount window credit are adjustment credit, seasonal credit, and extended credit.

· Adjustment credit helps depository institutions meet short-term liquidity needs. For example, an institution experiencing an unexpectedly large withdrawal of deposits may request ad­justment credit overnight or for a few days until it finds other sources of funding.

· Seasonal credit assists smaller institutions in managing liquid­ity needs that arise from regular, seasonal swings in loans and deposits, such as those at agricultural banks associated with the spring planting season.

· Extended credit may be provided to depositories experiencing somewhat longer-term liquidity needs that result from excep­tional circumstances.

In addition, the Federal Reserve has the power to extend emer­gency credit to entities other than banks, although it has not done so since the 1930s.

Adjustment credit helps depository institutions meet temporary liquidity needs arising from short-term fluctuations in assets and liabilities. Three basic principles govern the provision of adjust­ment credit:

· The Federal Reserve Bank provides credit at its own discretion.

· Borrowing must be for an appropriate reason.

· The borrower must seek other reasonably available sources of funds before turning to the discount window.

No fixed rules define an appropriate reason for borrowing. Some common situations that are appropriate for borrowing include meeting liquidity needs arising from an unexpected loss of deposit or nondeposit funding, avoiding unexpected overnight overdrafts in the institution's reserve account, or meeting liquid­ity needs arising from operational problems beyond the institu­tion's control or from an external event such as a natural disaster.

Discount officers apply judgment also in determin­ing whether an institution has sought all other rea­sonably available sources of funds before turning to the window. For example, most large institu­tions are presumed to have greater access to alter­native funding sources than small community banks have. Branches and agencies of foreign banks, even if they are not large, are presumed to have access to funding in national markets and from their foreign parents or affiliates. Depositories that are mem­bers of multibank holding companies are expected to seek funding from affiliates before turning to the window. Institutions that have access to a special industry lender, such as the Federal Home Loan Bank System, are expected to use these sources before requesting an advance from the discount window.

When reviewing a borrowing request, discount officers consider other pertinent information at their disposal, such as information from the institution's primary supervisor, balance sheet informa­tion, the frequency and amount of past borrowing, and the institution's general management of its reserve account. While borrowing under the adjustment credit program, institutions pro­vide daily balance sheet data to the Federal Reserve for monitor­ing purposes. Discount officers carefully review these data to en­sure that adjustment credit is not being used inappropriately, such as to fund a planned increase in loans, securities, or federal funds sales or a predictable decline in deposit funding or other liabilities.

A significant factor that affects the level of adjustment borrowing is the spread between the federal funds rate and the discount rate. Partly because discount officers routinely monitor banks to ensure that borrowing requests are for appropri­ate reasons and partly because the market pays close attention to banks that might be relying on discount window credit, most banks are generally reluctant to borrow at the discount window. A positive spread between the federal funds rate and the discount rate (that is, a federal funds rate higher than the discount rate) provides a pecuniary inducement to borrow. When reserves are in heavy demand or short supply, the spread between the federal funds rate and the discount rate tends to widen, encouraging more institutions to overcome their reluctance to borrow. The re­sulting injection of borrowed reserves helps to alleviate reserve market pressures and to moderate any unexpected spikes in the federal funds rate. In this way, adjustment borrowing serves as a safety valve that relieves short-term pressures in the reserves market.

The level of adjustment borrowing has declined on balance since 1980. This trend reflects several factors. During a period in which many banks were failing, banks became concerned that the mar­ket might detect borrowing at the window and interpret it as a sign of financial weakness. Also, a relatively narrow spread be­tween the federal funds rate and the discount rate reduced the pecuniary incentive to borrow. Finally, various measures imple­mented by the Federal Reserve in recent years to reduce risk in the payments system have generally led depositories to monitor their reserve account positions more closely during the day and conse­quently they can more promptly respond to unexpected funding losses without relying on discount window credit. The downward trend in adjustment credit notwithstanding, the Federal Reserve encourages banks to turn to the window in appropriate circum­stances. Only in this way can the discount window continue to fulfill its role as a safety valve in the reserves market.

Adjustment borrowing and the spread of the federal funds rate over the discount rate

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