Fed looks for new ways to pump more money into banks

Fed Seeks to Ease Money Market Strains

By Krishna Guha
Financial Times, London
Sunday, December 2, 2007

http://www.ft.com/cms/s/0/3e0543e8-a116-11dc-9f34-0000779fd2ac.html?ncli...

WASHINGTON -- The Federal Reserve is considering new steps to make liquidity more readily available to financial institutions in the hope of easing strains in the money market.

Analysts close to the Fed believe that a cut in the rate at which it lends directly to banks and steps to reduce the stigma associated with such borrowing are under active consideration. They believe the Fed could announce plans to cut the discount rate at which it lends directly to banks by 25 basis points to 4.75 per cent.

That would halve the interest penalty on discount window borrowing compared to the main interest rate, the Fed funds rate, which is currently 4.5 per cent.

The reduction of the discount rate penalty could come before the next meeting of the Federal Open Market Committee on December 11 if credit market conditions remain highly stressed. Alternatively, the Fed may cut the discount rate by an extra 25 basis points over and above any reduction in the Fed funds rate at that meeting, the analysts said.

However, the Fed is unlikely to eliminate the discount rate borrowing penalty altogether, as some pundits suggest. This is because such a step would allow a large number of small banks to obtain funds at less than their usual spread over the Fed funds rate, and would complicate efforts to manage that rate through the open market.

At the same time the Fed was considering ways to try to reduce the "stigma" associated with using the discount window, in order to make it more effective as a backstop to the money markets, the analysts said.

The Fed tried to overcome the stigma factor earlier in the crisis by telling banks it would view use of the discount window facility as a sign of strength, and by encouraging the top US banks to draw funds at the same time.

In a speech last week Don Kohn, Fed vice chairman, said this approach had "some success" at least for a time in reducing money market strain.

But he said the effectiveness of the direct lending operation was still being undermined by banks' fear that using it would be seen as a sign that they needed emergency funds.

The problem of stigma is even greater in the UK where, following the Northern Rock debacle, banks are afraid of tapping funds from the Bank of England.

He said all central banks -- not just the Fed -- had to find new ways to ensure that their liquidity support facilities remained effective in times of crisis.

Making the Fed discount window more usable is particularly important because all banks can pledge a wide range of securities in return for cash at this facility.

Only a small number of primary dealers can access cash from the Fed through its main market liquidity facility -- open market operations to control the fed funds rate -– and the list of collateral that can be pledged is much narrower.

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