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Federal discount rate

The federal discount rate is a concept you need to understand. Here’s what it means.

What is the federal discount rate?

The federal discount rate is the rate of interest paid by financial institutions to borrow overnight reserve funds from the Federal Reserve’s lending facility, also called the discount window. This is separate from the federal funds rate, the interest rate banks charge each other for overnight reserve funds.

Deeper definition

The Federal Reserve requires banks and other financial institutions to hold a certain amount of money in reserves at the end of each business day to ensure customers can access their funds and to protect against bank failures. This is referred to as the reserve requirement. The reserve requirement is approximately 10 percent of the deposits made at a financial institution. For example, if a bank has deposits of $100,000,000, the bank’s overnight reserve requirement would be roughly $10,000,000.

If a bank is short on reserves at the end of the business day, they must borrow funds to meet the reserve requirement. Banks typically borrow additional overnight funds from each other, but if for some reason a bank is unable to borrow from other institutions, it must borrow from the Federal Reserve’s discount window.

There are three types of discount rates: primary, secondary, and seasonal. Most banks borrow at the primary rate, which is a short-term loan for stable institutions. Banks in a difficult financial condition are required to borrow at the secondary rate. The seasonal rate is primarily for smaller, community-focused banks that have fluctuating needs over the course of the year. These banks may serve college communities with a seasonal influx of students or a resort community with seasonal changes in population.

The Federal Open Market Committee (FOMC) meets eight times a year and sets the the federal funds rate, depending on the needs of the economy. The Board of Governors of the Federal Reserve sets discount rates that are in line with the federal funds rate.

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Federal discount rate example

Investment bank Pierce & Pierce has seen several of its energy sector deals go sour in the ongoing oil price collapse. These developments have sapped capital from the firm and made it challenging to meet its reserve requirements. Moreover, an emerging financial crisis is starting to impact the United States financial sector, and Pierce & Pierce finds that it cannot borrow funds at a reasonable rate from another bank to meet its overnight reserve requirements. These difficult circumstances would force the firm to borrow from the Federal Reserve’s discount window.

This is what happens when the Federal Reserve raises interest rates.

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