The bank failures in spring 2023 have increased recognition of the importance of the discount window for liquidity risk management. The focus on discount window preparedness is a welcome development, but any new liquidity requirement should be developed thoughtfully and with input from all stakeholders. This note describes 10 pitfalls the banking agencies should seek to avoid when making changes to liquidity regulations.
There appear to be several different approaches floating around for encouraging banks to be more ready to borrow. A month ago, a report by the Group of Thirty recommended that each bank be required to have discount window borrowing capacity that, when combined with deposits at the Fed, exceed uninsured deposits and short-term funding. A week later, Acting OCC Comptroller Mike Hsu recommended that banks be required to have discount window borrowing capacity and reserves available in an amount at least as large as potential five-day outflows under severe liquidity stress. Another possibility that frequently arises in conversations is requiring each bank’s discount window borrowing capacity and deposits at the Fed to exceed 40 percent of the bank’s uninsured deposits. A bit further back, two weeks before SVB failed, BPI recommended that the banking agencies put increased emphasis on discount window borrowing capacity when evaluating the liquidity condition of commercial banks through the examination process (in particular, the internal liquidity stress tests) and conduct a holistic review of liquidity regulations.
The common thread across these and other related proposals is a recognition that a bank that is prepared to borrow from the discount window is more liquid than one that isn’t, and that weaving that notion into regulatory and supervisory assessments of bank liquidity would make those assessments more accurate and increase incentives for banks to be prepared. Moreover, being allowed to resolve greater needs for short-term contingency funds with discount window capacity rather than reserve balances allows banks to devote more of their balance sheet to lending to businesses and households – loans that can then be pledged to the Federal Reserve as collateral – rather than expanding even further their loans to the government in the form of even larger deposits at the Fed.
For example, in a speech on February 12, Andrew Bailey, Governor of the Bank of England, rejected the idea of responding to the rapid deposit outflows observed in the spring by simply requiring banks to hold ever larger amounts of government debt and deposits at the central bank:
I don’t think the answer is that simple. This would amount to saying that banks should self-insure more. But it would move banking significantly towards a narrow bank model which would disrupt the process of credit creation – lending – in the economy, with negative economic consequences. Supporting economic activity is an important part of so-called fractional reserve banking, in which only part of deposit liabilities are backed by banks in highly liquid assets. Changing this arrangement does not strike me as the right way to go. The alternative, and better way I think, is to supplement the existing liquidity regime with more ready access for banks to liquidity insurance at the Central Bank, which is appropriately priced and risk managed. This could be alongside more targeted adjustments to the liquidity regime, perhaps aimed at firms with more vulnerable business models, and for banks to be prepared to access liquidity insurance to monetise assets at speed.
Enabling banks to shift away from deposits at the Fed as a significant component of their liquid assets would have the added benefit of allowing the Fed to get smaller and less involved in the financial system on a day-to-day basis. Indeed, if the Fed were to return to its pre-GFC approach to conducting monetary policy, interbank markets, which have been decimated by the deluge of liquidity caused by the Fed’s inflated balance sheet, would recover. Claudio Borio, head of the Monetary and Economic Department at the Bank for International Settlements and a global expert on central bank operating frameworks, recognized the