discount rate

Sometimes a bank is short of cash for a day or two — perhaps a lot of customers withdrew money at once — and it cannot easily borrow from other banks. For these moments the central bank keeps a back door open: it will lend directly to banks, usually overnight, against good collateral. The interest rate it charges on these direct loans is the discount rate, and the facility itself is often called the 'discount window.' It is the central bank acting as the banking system's emergency cash machine.

The discount rate is usually set a little above the policy rate, deliberately. The central bank wants banks to borrow from each other first (at the cheaper market rate) and to come to the discount window only as a backstop. For example, if the policy rate target is 5 percent, the discount rate might be 5.25 percent. By capping how high the interbank rate can climb — no bank will pay 6 percent to another bank when it can borrow from the central bank at 5.25 percent — the discount rate forms a ceiling that helps keep market rates from spiking. Changing the discount rate is also a signal of the bank's policy stance.

In practice the discount window matters most in a crisis, when normal interbank lending freezes up and banks have nowhere else to turn. This is the lender-of-last-resort role in action. A subtle problem: banks sometimes avoid the window even when they need it, fearing it makes them look weak ('stigma'). Central banks have at times had to redesign the window or lower the rate to overcome this reluctance, because a backstop nobody dares use is not much of a backstop.