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The first line of defense: the discount window during the early stages of the financial crisis

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  • Elizabeth C. Klee

Abstract

This paper develops a theoretical model of trading in the federal funds market that captures characteristics of discount window borrowing and the federal funds market during the first year of the financial crisis, including the narrowing of the spread between the discount rate and the target rate; the increased incidence of high-rate trading; and the decline in participation in the federal funds market. The model shows that differences in stigma of borrowing from the discount window across banks can cause the federal funds rate to rise, even when the spread between the discount rate and the target rate narrows. The model is then evaluated using both aggregate and institution-level data. The data suggest that in aggregate, federal funds volume brokered at rates above the primary credit rate and discount window borrowing both increased during the first stages of the crisis. Bank-level data suggest that institutions that went to the discount window paid lower rates in the federal funds market than banks that did not. This effect became stronger as the spread between the primary credit rate and the target rate narrowed, coincident with the intensification of the financial crisis.

Suggested Citation

  • Elizabeth C. Klee, 2011. "The first line of defense: the discount window during the early stages of the financial crisis," Finance and Economics Discussion Series 2011-23, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2011-23
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    References listed on IDEAS

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    1. Artuç, Erhan & Demiralp, Selva, 2010. "Discount window borrowing after 2003: The explicit reduction in implicit costs," Journal of Banking & Finance, Elsevier, vol. 34(4), pages 825-833, April.
    2. Erhan Artuç & Selva Demiralp, 2010. "Provision of liquidity through the primary credit facility during the financial crisis: a structural analysis," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 43-53.
    3. Wooldridge, Jeffrey M., 1995. "Selection corrections for panel data models under conditional mean independence assumptions," Journal of Econometrics, Elsevier, vol. 68(1), pages 115-132, July.
    4. Daniel L. Thornton, 2008. "Walter Bagehot, the discount window, and TAF," Economic Synopses, Federal Reserve Bank of St. Louis.
    5. Gara Afonso & Anna Kovner & Antoinette Schoar, 2010. "Stressed not Frozen: The Fed Funds Market in the Financial Crisis," NBER Working Papers 15806, National Bureau of Economic Research, Inc.
    6. Gara Afonso & Anna Kovner & Antoinette Schoar, 2011. "Stressed, Not Frozen: The Federal Funds Market in the Financial Crisis," Journal of Finance, American Finance Association, vol. 66(4), pages 1109-1139, August.
    7. Stavros Peristiani, 1998. "The Growing Reluctance To Borrow At The Discount Window: An Empirical Investigation," The Review of Economics and Statistics, MIT Press, vol. 80(4), pages 611-620, November.
    8. Semykina, Anastasia & Wooldridge, Jeffrey M., 2010. "Estimating panel data models in the presence of endogeneity and selection," Journal of Econometrics, Elsevier, vol. 157(2), pages 375-380, August.
    9. Bartolini, Leonardo & Hilton, Spence & McAndrews, James J., 2010. "Settlement delays in the money market," Journal of Banking & Finance, Elsevier, vol. 34(5), pages 934-945, May.
    10. Bech, Morten L. & Klee, Elizabeth, 2011. "The mechanics of a graceful exit: Interest on reserves and segmentation in the federal funds market," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 415-431.
    11. John A. Weinberg & Huberto M. Ennis, 2009. "A Model of Stigma in the Fed Funds Market," 2009 Meeting Papers 956, Society for Economic Dynamics.
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    Keywords

    Discount ; Federal funds ; Global financial crisis;

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