In the early days of the COVID pandemic, the Federal Reserve and central banks around the world pulled out all the stops. Policy rates have been lowered to zero interest rate policy (ZIRP) levels, facilities have been extended to provide liquidity to companies having difficulty selling securities in the primary and secondary markets, and direct lending to individuals and companies has reached unprecedented levels. Programs targeting niche markets have reopened, such as the Commercial Paper Finance Facility (originally introduced during the 2008 crisis). And the Federal Reserve’s discount window, where depository institutions can pledge bundles of loans, investment-grade securities, and other guarantees for emergency financing, has seen its use soar, rivaling the darkest days of 2008.
Because of its nature (the discount window is usually marketed as a relief valve for stressed financial institutions, which may herald problems with financial stability) there is a stigma attached to its use. This is not entirely justified, as there are certainly companies that use the discount window periodically without liquidity problems. A notable example is those of small banks that face significant seasonal and/or unexpected business fluctuations.
Using the Fed’s discount window tends to be seen as a concern among other banking firms, despite the caveats. The measure taken to facilitate the use of the discount window without the effect of freezing the borrowing institution out of other lending markets is to introduce a two-year gap between the use of the window and the Federal Reserve’s issuance of the names of the borrowing companies.
Fed discount window, primary credit activity (2003–present)
As expected, discount window utilization skyrocketed early in the COVID outbreak. When markets calmed down and uncertainty abated, federal lending through this facility gradually diminished, returning to negligible levels. But recently, throughout the second half of 2022, discount window utilization has started to pick up. The big question is: Is what we are seeing just an increase in exceptional non-crisis borrowing, or is a new financial crisis brewing? The two-year blackout on public disclosure of the borrowers’ identity makes consideration of the possibilities a particularly speculative process.
Discount window lending is done against collateral, as already mentioned, at above-market rates. (Much of what the discount window contemplates aligns with Baghot’s 1873 rules for central bankers, including “lend freely against good collateral against fine.”) [interest] rate. It is certainly possible for activity in the window to be conducted as a backup (instead of a regular source of research), as required by the function of the primary discount window. Lending to depository institutions not eligible for primary credit may also be extended, as secondary credit allows for the discount window. It is certainly conceivable that the volatility of banking in an inflationary period exacerbated the normal seasonal requirements of firms facing such requirements.
VIX Index, S&P 500 Index, US Dollar Index, US Treasury High Yield Spread / 10 Year (2022)
But 2022 was an unusual year with exceptional stress, especially for financial institutions. It began with a large-scale conventional war in Southern Europe, which led to an escalation of global tensions. Equity and fixed income markets slumped, commodity prices soared, and between the rise in the dollar and the fall of other currencies, the foreign exchange markets experienced high levels of simultaneous generational volatility. A brief recession hit the United States, as the highest rate of inflation to hit the US in forty years was met by the fastest rate hike ever by the Federal Reserve. In addition to all this, the cryptocurrency sector snatched the long-standing suspicion from the jaws of the public’s grudging acceptance with a drumbeat of scandals and falling coin prices.
Against this backdrop, the idea of a financial institution (or institutions) quietly struggling to survive cannot be ignored. One would imagine that most of the accountants, comptrollers, and chief financial officers currently working have had experience from the economic conditions that prevailed throughout 2020, and that quite a few have been around long enough to remember the debacle of 2008. However, it is likely that a few will have been in their current roles during The 1970s, when inflation raged and interest rates steadily fell. Inflation accounting and hedging interest rate exposure, as of the beginning of 2021, were skills not required of US-based firms for a very long time. The notion that a financial institution, commodity marketer, hedge fund, or combination of these might need emergency liquidity is within the realm of the imaginable.
Fed Discount Window, Core Credit Activity and Target Midpoint for the Fed Funds Rate (2021-present)
The fact that amounts borrowed in the discount window are rising in a wobbly fashion with progressively higher “highs” and higher “bottoms” suggests, though not conclusively, that amounts borrowed are increasing as the Fed increases rates. The idea that rapidly rising interest rates would stress a company accustomed to borrowing at the ultra-low rates prevailing for 15 years seems counterintuitive, though the sawtooth pattern takes an extra guess. Any company with large fixed income portfolios is likely to experience losses in the market and therefore needs to shore up its balance sheets. And while the massive losses associated with cryptocurrency assets and companies in the wake of the collapse of Luna and FTX are unlikely to affect depository institutions directly, borrowers (and possibly depositors) are certainly not so lucky.
Recent data shows that the growth rate of the M2 money supply turned negative in November 2022; The M1 money supply followed in December 2022. For the first time since 1994, in nearly 30 years, the money supply is shrinking rapidly.
Annual Growth Rate of M1 and M2 Monetary Aggregates (January – December 2022)
Thus, monetary conditions are changing rapidly, and financial conditions may be tighter under the guise of banks and financial institutions than they appear on the surface.
Those forewarned have been excused, but over the past two decades it has become impossible to parody. Nothing conclusive yet. In about 18 months, the identity of the companies that were tapping into the Fed’s discount window starting in March 2022 will become public. If these funding requests stemmed simply from getting over the lingering effects of the economic turmoil of 2022, we will learn by then. If something worse is brewing, much sooner.