Fed May Face Challenges in Overcoming Stigma of Backstops Amid New Initiative

By Paritosh Bansal

The U.S. Federal Reserve is urging banks to utilize its previously underused cash backstop mechanisms to further its monetary policy and financial stability objectives. Despite these efforts, significant changes may remain elusive.

The Fed provides two key credit backstop facilities: the discount window and the Standing Repo Facility (SRF). These allow lenders to obtain cash by pledging collateral, such as Treasury bonds. Besides providing liquidity, these tools can also serve as instruments for influencing interest rates and keeping them aligned with the Fed’s policy rate. However, many banks hesitate to use these options, primarily because doing so may indicate financial strain.

In an attempt to alleviate these concerns, the Federal Reserve announced in August that banks could consider these backstops as viable cash sources when conducting internal liquidity stress tests, which are regular assessments that large banks undertake to demonstrate their ability to quickly access cash during emergencies. In September, Michael Barr, the Fed’s regulatory chief, reiterated that liquidity regulations should support market functioning and help facilitate effective monetary policy.

In recent weeks, banking industry experts have critiqued the potential effectiveness of the Fed’s changes. Overall, they believe that while increased readiness among banks to use these facilities could enhance financial stability, overcoming the associated stigma may be challenging and might not significantly impact monetary policy.

“The issue of stigma has persisted since the 1920s. It’s complex and significant, requiring considerable effort to tackle,” remarked Bill Nelson, chief economist at the Bank Policy Institute.

A senior bank executive, speaking anonymously, highlighted the gap between policymakers’ goals and the reality faced by supervisors. “If one were to access the discount window for any reason, the immediate inquiry would be from your supervisor, questioning the situation,” the executive noted.

Regarding the intended impact on monetary policy, the Fed hopes that allowing banks to depend on these backstops could lessen their reliance on reserves held at the central bank. Currently, banks heavily depend on reserves to meet contingency funding requirements in their stress tests. With the Fed’s recent guidance, more liquid assets like Treasury securities may serve as substitutes.

If this theoretical framework holds, it could provide the Fed with greater flexibility to tighten monetary policy, as the financial system requires a certain level of reserves for smooth operation, especially as the Fed reduces its balance sheet.

This moment appears favorable for the Fed’s strategy, as SRF usage reached its highest levels since its inception in 2021 during the third quarter. This uptick has caught the Fed’s attention as it monitors liquidity conditions in the financial system.

Nevertheless, the anonymous banker expressed skepticism about the practical effects of the Fed’s clarification, given that larger banks are subject to additional liquidity tests where they cannot account for Fed backstops. The liquidity coverage ratio, for instance, mandates that large banks hold an adequate amount of high-quality liquid assets, such as Treasuries, to address cash needs during stress periods.

Barr also indicated a desire to propose further modifications to liquidity regulations, which might prompt banks to decrease their Treasury holdings, according to the bank executive.

On another front, regulators have made substantial progress in tackling financial stability issues since the bank failures in March 2023, with a concentrated effort to ensure that more banks are prepared to use these backstop facilities if necessary. The collapse of Silicon Valley Bank was partly attributed to its inadequate preparations to access the discount window, resulting in critical delays.

Since that event, more than $1 trillion in collateral has been pledged to the discount window, and additional banks have enrolled in the SRF, as noted by Barr.

According to Nelson, liquidity risk stems from a market failure where a solvent institution—holding assets that exceed its liabilities—struggles to convert those assets into liquidity promptly and at a reasonable cost. Borrowing from the discount window can rectify this situation.

However, some experts argue that the central bank’s emphasis on normalizing access to the discount window post-March 2023 is misplaced, suggesting instead that addressing interest rate risk should take precedence.

“I don’t believe the stigma around the discount window was the source of those institutions’ failures,” said Jill Cetina, a former Dallas Fed official now serving as a finance professor at Texas A&M University. “The real issues were excessive levels of interest rate risk and liquidity problems.”