This is an archived article that was published on sltrib.com in 2011, and information in the article may be outdated. It is provided only for personal research purposes and may not be reprinted.
Recent revelations about the billions of dollars that Utah financial companies borrowed from the Federal Reserve discount window during the financial crisis that began in 2007 shed new light on the central bank's oldest and most debated emergency-lending program.
The window goes back to 1913, when Congress established the Fed, but controversy swirls around it today.
Back in the day, lending money through the window was intended to be the central bank's main channel for controlling the supply of money in the economy. Over time, however, the window has been superseded by open-market operations, such as buying and selling government bonds, as the Fed's most important tool for influencing interest rates and the money supply.
And as the window fell out of the spotlight, a mark of disgrace became associated with banks that borrowed money from the lending program, University of Utah finance professor Scott Schaefer said.
"From the Fed's point of view, the purpose of the window is to help financial institutions with liquidity problems. What that means is that, when banks have temporary cash problems, the Fed hopes to help them get through those temporary cash problems so they can continue to lend money [and] to stay open," he said.
"The idea is that the Fed will be the lender of last resort when solvent banks can't get cash from anywhere else," Schaefer said.
Although the Fed says it attaches no stigma to borrowing from the window, most bank executives think otherwise.
Because the lending program is billed as the last refuge for a bank that can't borrow anywhere else, going to the window often is seen as a sign of weakness among regulators and its rivals.
"One place a bank could get cash could be the discount window and the other is from another bank," Schaefer said.
"Because the interest rate [that banks charge each other] is lower [than the discount window rate], the banks prefer to get funds from other banks. If you are borrowing from the discount window, it means you are having trouble getting funds from elsewhere," he said.
As the financial crisis of 2007-08 worsened, credit markets froze. After the bankruptcy of Lehman Brothers in September 2008, financial companies stopped lending to each other and began hoarding cash as they awaited the outcome of the government's $700 billion bailout plan.
In October 2008, the three-month London Interbank Offered Rate, an index that tracks how much banks charge each other for overnight loans, reached 4.1 percent.
The interest-rate spread between the Libor and short-term government debt soared. Usually at about 0.5 percent, the gap widened to as much as 4.5 percent — a sign that lenders feared the risk of default on interbank loans was high.
"There were concerns about every bank's future. Banks stopped lending to each other because the banks didn't trust each other," Schaefer said. "When that happened, the interbank rates just went through the roof … that pushed all the banks to the discount window," where they could get overnight loans for as little as zero to 0.25 percent.
In total, the Fed lent as much as $111 billion to a variety of U.S. and foreign banks through the discount window during the period of August 2007 to March 2010. Utah financial companies borrowed almost $9.5 billion.
James Abbott, in charge of investor relations for Zions Bancorp, whose Zions Bank subsidiary borrowed $234 million, said the Fed told banks they would not be regarded with suspicion if they sought cash from the window.
"They actively encouraged the use of the discount window in order to prove the concept [of providing cash to banks when confidence collapses] and to remove any doubt from depositors that banks would have sufficient liquidity," he said.
"Why was that important? The answer is, that if the average depositor lost confidence and went to withdraw money overnight, then the entire [banking] system could have collapsed.
"We were close. So it was extremely critical for the Fed to instill confidence that when your average depositor woke up the next morning that their bank would be alive."
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