Citibank Becomes Deputy Dawg

If I've got this right, the Fed’s innovative discount window action taken last week will have the effect of “deputizing” the commercial banks that come to its discount window with collateral from sources that are unable to tap the Fed for emergency funds. The key point of the discount window deal that has not been discussed in the media is what happens when the 30-day loan is due?

Unless I am mistaken (and if someone knows otherwise, please feel free to comment), as far as the Fed is concerned it is the commercial bank, and not the institution requesting the loan through the commercial bank, that is on the hook for the money when the 30-day loan is up. Therefore, since in the eyes of the Fed the loan is owed by the bank (and not the hedge fund or mortgage banker or investment bank, etc.) one can assume that the bank accepting the collateral for the loan will be very diligent in assessing the quality of the paper it will present to the Fed as collateral. It is logical to then assume that the commercial bank will insist on strong assurances that the paper they accept and will present to the Fed for the discount window loan is good. Two things should occur from this arrangement:

• Temporary liquidity is provided where needed
• Transparency is improved

By deputizing the banks, the Fed may help further clarify the real credit risks in the system without compromising its market discipline philosophy.