By Steven K. Beckner

(MNI) – Banks were willing to pay higher interest to avoid
borrowing from the Federal Reserve’s discount window during the
financial crisis because of the “stigma” attached to doing so, research
released Wednesday by the New York Federal Reserve Bank shows.

This discount window “stigma” makes it harder for the Fed to
provided needed liquidity during crises, making it necessary for the Fed
to be ready to offer alternative borrowing facilities, the New York Fed
research paper argued.

The Fed did in fact offer an alternative early in the crisis — the
Term Auction Facility or TAF. And the research finds that banks were
willing to bid to borrow at higher rates from the TAF rather than borrow
from the discount window, even though the window loans had been
liberalized and the Fed was urging banks to use it.

The paper also warns that increased “transparency,” i.e. revealing
the identities of borrowers, could further increase the stigma,
complicating the Fed’s performance of its “lender of last resort” role
in the future. It was written by New York Fed economists Olivier
Armantier, Asani Sarkar and Jeffrey Shrader, along with Eric Ghysels of
the University of North Carolina (UNC) at Chapel Hill.

They find “evidence that during the recent financial crisis banks
were willing to pay higher interest rates in order to avoid going to the
discount window, a pattern of behavior consistent with stigma.”

“The existence of discount window stigma impedes the Fed’s ability
to supply funds to banks during times of crisis,” the paper concludes.
“Since we can never observe the maximum amount banks are willing to pay
to avoid the discount window, it is impossible to estimate the ‘stigma
premium’ precisely. This suggests that facilities designed to be
‘stigma-proof’ would complement the discount window during crisis
periods.”

As the housing bubble burst and financial dominoes began to fall in
late 2007, the Fed took a series of actions to provide emergency
liquidity, first using traditional tools. It reduced the discount window
rate premium or “penalty” above the federal funds rate from 100 to 50
basis points on Aug. 17, 2007. And it extended the term of discount
window financing from overnight to as long as thirty days.

What’s more, the Fed issued statements encouraging banks to go to
the discount window, telling them it would be seen as a sign of
strength, not weakness.

(As the crisis deepened, on March 16, 2008, the Fed further
narrowed the spread between the discount rate and the federal funds rate
to 25 basis points. The spread was widened back to 50 basis points on
Feb. 18, 2010, but remains at half of pre-crisis levels.)

When banks continued to avoid the discount window despite worsening
liquidity problems, the Fed in December 2007 launched the TAF, by which
banks could bid at auction for 28-day or 84-day credits using the same
collateral that was eligible for discount window loans.

Because the TAF was viewed as more secure in terms of market
participants not getting wind of the identities of the borrowers, TAF
credit extensions immediately shot up relative to discount window
lending.

As the New York Fed economists write, “from the start of the TAF
program, the amount of funds bid for and allocated at TAF was
substantial, indicating that little or no stigma was attached to TAF
borrowing.”

They note this was true even though the TAF had some disadvantages
relative to the discount window. For example, discount window loans
could be prepaid but TAF loans could not.

“Therefore, if the discount window and TAF loan rates were equal,
rational banks should not have preferred borrowing from the TAF, unless
there was a stigma attached to discount window borrowing,” they write.

In fact, banks were willing to pay more to borrow at TAF auctions,
the researchers find.

“For the period December 17, 2007, to September 22, 2008 … a
large percentage of banks participating in the TAF bid above the
prevailing discount window rate,” they write. “On average, 56% of banks
bid above the discount window rate during this period.”

“So, for these auctions, banks received funds at a rate that was
higher than the prevailing discount window rate,” they go on. “Moreover,
these high bids cannot be chalked up to occasional mistakes by a few
banks, since half of all banks bid above the discount window rate at a
majority of the TAF auctions that they participated in.”

“All in all, these results provide strong evidence of discount
window stigma by showing banks’ desire to avoid the discount window even
if it meant paying potentially higher interest rates for a TAF loan,”
they add.

They find that on average, banks were willing to pay at least
$17.80 million more per auction to avoid the discount window and up to
$164.40 million more in the auction just after Lehman Brothers’
bankruptcy in September 2008.

“It appears that, during the highly uncertain times following
Lehman’s bankruptcy, banks were willing to go to great lengths to avoid
the perception that they were financially weak,” the economists write.

Analyzing TAF auctions where the stop-out rate exceeded the
discount window rate, they find that “for banks that bid above the
discount window rate at these auctions and subsequently received funds
at the stop-out rate, the additional cost was at least $6.70 million per
auction, representing more than 9% of their interest payments on TAF
loans.”

“These numbers rise to $74.70 million per auction and 40% of
interest payments in the auction after the Lehman bankruptcy,” they
further find. “In other words, banks could have substantially lowered
their interest payments if, instead of borrowing from the TAF, they had
borrowed from the discount window.”

The paper concludes that “stigma-proof” facilities are needed to
“complement” the discount window at times of crisis.

Although the TAF expired on March 8, 2010, when the last auction of
term funds was held, it is believed the Fed will keep the TAF on the
shelf and dust it off in the event of another crisis.

The researchers also conclude that, if anything, the discount
window stigma may have been increased by efforts to promote
“transparency.

“The identities of discount window borrowers were not disclosed by
the Fed,” they write. “Yet, discount window stigma existed because of
the fear that market participants could somehow ferret out the
identities of borrowers. Initiatives to increase transparency in Fed
liquidity programs could increase stigma to the extent that they make it
easier to identify discount window borrowers on a timely basis.”

“Recognizing the possible adverse consequences of real-time
disclosure, the Dodd-Frank Wall Street Reform and Consumer Protection
Act, passed in July 2010, requires the Fed to make public the identity
of discount window borrowers only after a lag of two years,” they note.

** Market News International **

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