The Fed stands ready with overdrafts as the lender of last resort, but there is a greater price to pay than the penalty rate — loss of institutional credibility and reputation due to either sub-standard ALM practice or financial weakness. The Fed attempted to change that in 2003, and even tried to reverse the perception at the time of the financial crisis as part of its gargantuan effort to stabilize the system.
The post-reform DW is more consistent with Walter Bagehot’s classical principles that central banks should lend freely to illiquid but solvent institutions against good collateral but at a penalty over the “normal” market rate. By lending freely, central banks create an expectation that they will be available to provide as much liquidity as is needed during a crisis and alleviate the high demand for liquidity that triggers most crises. By charging a penalty rate, they ensure that banks borrow as a last resort.FRBNY— Liberty Street Economics
The 2003 reforms, however, do not appear to have removed the perception of DW stigma, as shown in “Discount Window Stigma during the 2007-2008 Financial Crisis,” and DW borrowing generally remained sparse (see the second chart, above). A plausible explanation for the persistence of DW stigma is that the old policies left lasting perceptions of the DW, which, among other factors, may have dissuaded banks from readily using it to this day.
History of Discount Window Stigma
