Cornell Law Review Volume 99 Issue 4

Three Discount Windows

It is widely assumed that the Federal Reserve is the lender of last resort
in the United States and that the Fed’s discount window is the primary mechanism
through which it fulfills this role. Yet, when banks faced liquidity
constraints during the 2007–2009 financial crisis (the Crisis), the discount
window played a relatively small role in providing banks much needed liquidity.
This is not because banks forewent government-backed liquidity;
rather, they sought it elsewhere. First, they increased their reliance on collateralized
loans, known as advances, from the Federal Home Loan Bank
System, a little-known government-sponsored enterprise that grew in size to
over $1 trillion during the Crisis. Second, distressed banks offered exceptionally
high interest rates on insured deposits, enabling them to retain and attract
funds from depositors. As a result, Federal Home Loan Bank advances
and insured deposits served as “alternative discount windows,” standing
sources of government-backed liquidity that banks relied on as market conditions

In addition to drawing attention to the important and largely overlooked
role that the alternative discount windows played during the Crisis,
this Article considers the normative implications of banks’ capacity to obtain
government-backed liquidity without going to the Federal Reserve. The analysis
reveals both benefits and costs. As a result of the changing nature of
banking and financial intermediation, the Fed’s discount window alone
cannot meet the liquidity needs of a modern financial system in distress. By
facilitating the transfer of additional liquidity to the market during crisis
periods, the alternative discount windows may reduce the adverse systemic
consequences that arise from liquidity shortages. Yet, there are also significant
costs. In contrast to the Fed, the Federal Home Loan Banks and insured
depositors lack the incentives and competence needed to understand the
systemic consequences of their actions. As a result, the provision of liquidity
through the alternative discount windows tends to facilitate inefficient risk
taking, increase moral hazard, reduce regulatory accountability, and compromise
information generation, in addition to adversely affecting healthy
banks. This Article accordingly concludes by proposing ways to reform the
underlying programs to reduce the costs of having alternative discount


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