Many small US banks are unprepared to borrow from the Fed in an emergency.
Many small US banks are unprepared to borrow from the Fed in an emergency.
The Inconvenient Truth: Banks Unprepared for Borrowing from the Federal Reserve
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In the spring of this year, the rapid collapse of Silicon Valley Bank (SVB) brought to light a startling reality – some U.S. banks are ill-prepared to borrow from the Federal Reserve in times of need. A recent analysis by ANBLE indicates that this problem is most acute among the nation’s smallest banks. SVB, with over $210 billion in assets, failed to adequately test its access to the “discount window” through which the Fed provides emergency loans. This lack of preparedness may have hastened SVB’s demise, according to a review published by the Federal Reserve in April.
This vulnerability has become especially apparent as the aftermath of SVB’s failure prompted a surge in demand for emergency credit from the Fed. Concerns about banks’ readiness to borrow from the discount window have arisen both at the central bank’s headquarters in Washington and throughout the 12 Fed districts across the country. Federal Reserve Chair Jerome Powell acknowledged the clunkiness of utilizing the discount window during a news conference, emphasizing the importance of banks being better prepared for accessing it when necessary.
To underscore this message, the Fed and other bank regulators released updated guidance recommending that depository institutions incorporate the discount window into their contingency funding arrangements. Banks are urged to maintain operational readiness to tap into this emergency credit facility. However, an analysis of Fed data by ANBLE suggests that significant progress still needs to be made to achieve this goal.
Although SVB’s situation was unusual among its peers, with a majority of banks with over $100 billion in assets regularly testing their discount-window access, many smaller banks have not conducted tests and may be unprepared to borrow at all. Dallas Fed President Lorie Logan expressed surprise at the number of banks that were not fully equipped for the discount window, emphasizing the importance of all banks in Texas and the nation establishing access and “testing the plumbing.”
The Fed’s Critical Mission
Despite the spotlight on the Federal Reserve for its role in setting interest rates, its most critical mission is much more fundamental – providing loans when no one else will. Established in the early 20th century with the aim of ending the frequent bank panics that plagued the economy, the Fed possesses an extensive capacity to offer credit to banks during times of crisis, ensuring stability in the broader financial system.
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However, there is a catch. Banks must be willing to seek that financial lifeline when needed, and they must be adequately prepared to do so. Although borrowing from the Fed may seem straightforward, it involves paperwork, collateral requirements, and conducting regular test runs. Central bank data reveals that there are many banks that have not taken advantage of the discount window, either to borrow funds when necessary or to test the process.
Size Matters
Generally, smaller banks are less likely to have utilized the discount window. From July 2010 to June 2021, almost all banks with assets exceeding $50 billion and approximately 70% of banks with assets over $1 billion borrowed from the discount window at least once, either in small amounts suggesting tests or in larger amounts indicating actual need. In contrast, only around 40% of the approximately 1,800 banks with assets between $250 million and $1 billion nationwide accessed the discount window during that time. In Dallas Fed President Lorie Logan’s district, which includes Texas, parts of New Mexico, and Louisiana, this figure was approximately 20% for small banks. For the smallest banks with less than $250 million in assets, less than a fifth of them nationally tapped into the window.
The data from the Federal Reserve provides details on over 40,000 transactions, ranging from small loans to large-scale borrowing. Within the examined 11-year period, about 3,800 banks borrowed from the discount window, accounting for just over 40% of the depository institutions entitled to borrow from the Fed. However, there are limits to the information provided by this data. It does not include banks that may have filed the necessary paperwork and posted collateral but did not actually make use of the discount window. Additionally, it does not encompass any banks that have recently established access or conducted tests since 2021 – especially in light of SVB’s collapse, which highlighted the importance of liquidity. The Fed releases discount window transaction data with a two-year lag.
Nevertheless, according to Richmond Fed ANBLE Huberto Ennis, it is reasonable to assume that a significant proportion of banks did not have ready access to the discount window, at least until recently. ANBLE reached out to the ten largest banks with no public record of borrowing from the discount window. Most of them indicated in public filings that they had pledged collateral at the Fed, and some stated that they had tested their access, albeit without specifying dates. The National Credit Union Association requires its members with assets exceeding $250 million to have access to the discount window or other emergency liquidity options. Only 1,100 out of 4,700 members meet this threshold, while 1,366 were signed up to use the discount window as of December, according to the NCUA.
While banks are not subject to a similar requirement, Fed Governor Michelle Bowman mentioned in May that “a number” of banks had not registered for discount window access. VeraBank, a $4.5 billion bank in Henderson, Texas, has been testing its discount window access for years, borrowing $100,000 every July and repaying it the next day. CEO Brad Tidwell stresses the importance of testing access regularly, emphasizing that one can never be certain when it may be needed.
Prudent Planning and Future Preparations
According to historic practices, the Fed discouraged banks from borrowing from the discount window. It imposed conditions such as exhausting alternative funding sources first and charging above-market interest rates. However, when the COVID-19 pandemic struck, the Fed changed course. It reduced the so-called penalty rate and, in conjunction with other regulators, encouraged banks to borrow from the discount window as part of broader efforts to prevent market and credit disruptions. The largest banks also took on discount window borrowing to reduce the stigma associated with it.
With the aftermath of SVB’s collapse triggering market turbulence, the Fed expanded its emergency lending capabilities. It introduced a new one-year lending facility that lends at the full-face value of pledged collateral, without imposing a discount. The Fed is now officially promoting banks to sign up and test the discount window. This initiative forms part of a comprehensive campaign to achieve operational readiness, as stated by Chicago Fed President Austan Goolsbee. A recent webinar conducted by the Fed for bank executives offered detailed guidance on onboarding for emergency lending facilities, assuring supervisors’ perception of establishing and testing access as prudent planning rather than a liquidity concern.
According to Richmond Fed’s Ennis, not all small banks necessarily need access to the discount window. Some banks maintain substantial cash reserves or have correspondent relationships with larger banks. Additionally, most banks are members of their local Federal Home Loan Bank, which acts as the second-to-last resort lender, enabling them to source liquidity when necessary. However, Ennis’s research suggests that banks with riskier and less-liquid portfolios may find themselves in need of the discount window during periods of financial market stress.
Minneapolis Fed President Neel Kashkari advises small banks to view the discount window as a backup option, stating that there may come a time when the Federal Home Loan Bank cannot meet their needs. He emphasizes the importance of ongoing discussions with banks, as historical trends indicate that banks often assume they are fine until they are not.
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