An important function of a central bank is to act as the Lender of Last Resort (LOLR) by providing discretionary liquidity when the interbank market is unable to meet the demand for liquidity from the banking system (for example, due to asymmetric information problems) Freixas, Giannini, Hoggarth, and Soussa (1999). Typically, the Federal Reserve (”Fed” from now on) uses its discount window (henceforth DW) facility to lend against collateral (typically financial assets) to illiquid but solvent institutions.
Like any private lender, the Fed is concerned with managing its credit risk by adjusting the terms of discount window loans and by stipulating a haircut on collateral it receives. In theory, the discount window loan rate should be set below the break-even loan rate of a private lender who is unable to discriminate between good and bad credit (see Flannery (1996)). Indeed, prior to 2003, banks in distress could borrow from the discount window at a rate below the Federal Reserve target rate.
A consequence of setting rates below market, however, was that it created a perception of stigma associated with DW borrowing. In other words, institutions became concerned that borrowing from the DW indicated weakness both to competitors and the Fed and these concerns deterred them from DW borrowing even when they had an urgent need for funding. In response to possible adverse effects of stigma, the Fed increased the DW rate in 2003 to a penalty rate of 100 basis points above the target rate.
However, with the onset of the 2007 financial crisis, banks remained reluctant to borrow from the DW despite the Fed’s urgings and serious liquidity shortages. Consequently, the Fed lowered the penalty rate of DW borrowing to encourage banks to rely on its facility. In addition, the Fed urged banks that borrowing from the DW would be viewed as a sign of strength. But banks continued to stay away from the DW throughout the latter half of 2007. Finally, to improve its ability to supply liquidity to the banking system, the Fed created the Term Auction Facility (henceforth TAF) in December 2007. By lending term funds using an auction mechanism at market-determined rates, one of the Fed’s objectives in designing the TAF was to mitigate the stigma perceived to be associated with DW borrowing (see for instance Armantier, Krieger, and McAndrews (2008)).
In this paper, we use a detailed and unique dataset of borrowing by banks eligible to access both the DW and TAF facilities during the financial crisis period of 2007 to 2010. By identifying instances where a bank chooses to bypass the DW in order to bid for TAF funds at higher rates, we provide rigorous and robust evidence of the existence of stigma during the recent financial crisis. In particular, many banks submit bids above the DW rate at TAF auctions for a period of six months in 2008 when the TAF stop-out rates were consistently above the DW rate. Therefore, at these auctions, bidding above the DW rate would result in banks paying a premium over the DW rate. Moreover, about half of the banks bidding above the DW rate did so on a regular basis, indicating that the bids were not a result of idiosyncratic errors.
Next, we estimate a probit model to understand the factors that determine a bank’s choice of bidding above DW rates at TAF auctions. We find that banks who, anticipating a need for liquidity, have large amounts of collateral pledged to the Fed or increase their collateral pledge prior to an auction, are more likely to bid above DW rates. Consistent with this result, when general funding conditions worsen, as measured by higher spread between the Libor and OIS rates and by higher transactions volatility in the interbank markets, banks are more likely to bid above the DW rate.
