Problem Set #10: 1. Banks are reluctant to borrow from the Fed’s discount window

Question

Problem Set #10:

1. Banks are reluctant to borrow from the Fed’s discount window because it’s looked down on by other banks. Other banks think that if a bank needs to use the discount window, it’s probably not very healthy. Explain why.

2. So where you get your loan is a signal about what kind of bank you are. Which of the following would seem like bad sign?

a. Your friend borrows money from a federal student loan program.
b. Your friend borrows money from a payday loan store.
c. Your friends borrows money from his or her parents.
d. Your friends borrows money from an illegal loan shark.

Explanation / Answer

1. Banks are reluctant to borrow from the Fed’s discount window because it’s looked down on by other banks. Other banks think that if a bank needs to use the discount window, it’s probably not very healthy. Explain why. Banks that borrow from the Fed's discount window only do so if no other bank is willing to lend to them, because the Fed charges a much higher rate than do most commercial banks. Moreover, banks only seek to lend from one another when their own finances are not sound. Borrowing from the Fed's discount window is a sign that no other bank thinks your bank is "financially sound enough" to lend to, and moreover, that your bank even needs lending in the first place - i.e. that the bank doesn't have enough money to lend out.

This is the sort of thing that happened to the failed AIG and Bear Stearns. Borrowing from their unfortunate precedent, banks are highly reluctant to lend to similar, unsafe and financially unsound institutions.

2. So where you get your loan is a signal about what kind of bank you are. Which of the following would seem like bad sign?
a. Your friend borrows money from a federal student loan program.

b. Your friend borrows money from a payday loan store. The Fed is kind of like this payday loan store - a window of last resort.

c. Your friends borrows money from his or her parents.

d. Your friends borrows money from an illegal loan shark.

I hope that you found this answer useful towards your studies. It took quite some thought and effort to compose, and and I'd greatly appreciate a lifesaver rating! It would really make my day! :)

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