USE OF THE FEDERAL RESERVE'S PRIMARY CREDIT PROGRAM IN EFFECTIVE LIQUIDITY MANAGEMENT

On January 9, 2003, the Federal Reserve replaced two of its discount window programs - adjustment credit and extended credit - with new primary and secondary credit programs. Under the new primary credit program, Reserve Banks may extend short-term credit to eligible depository institutions at a rate above the target federal funds rate. The interest rate for primary credit was set initially at a level 100 basis points above the Federal Open Market Committee's target for the federal funds rate. This spread may change in light of experience with the new program. Generally, primary credit is extended on a very short-term basis, usually overnight.

The attached advisory outlines the easier administrative process of the new primary credit program, including that discount window borrowings can be secured with an array of collateral, requests for primary credit advances can be made anytime during the day and, there are no restrictions on the use of short-term primary credit. Except in unusual circumstances, Reserve Banks will not question depository institutions about their reason for borrowing primary credit. In general, depository institutions with composite CAMELS ratings of 1, 2, or 3 that are at least adequately capitalized are eligible for primary credit.

Federal Reserve Banks may extend secondary credit to depository institutions that do not qualify for primary credit. This program entails a higher level of Reserve Bank administration and oversight than primary credit. The secondary credit rate is above the primary credit rate. The spread was set at 50 basis points at the program's inception; it may vary.

The Agencies have long advised depository institutions that sound liquidity risk management requires well-established strategies, policies and procedures, liquidity risk measurement systems, adequate internal controls, and liquidity contingency planning. Adequate liquidity contingency planning is critical to the ongoing maintenance of the safety and soundness of any depository institution. Contingency planning starts with an assessment of the possible liquidity events that an institution might encounter. The types of potential liquidity events considered should range from high-probability/low-impact events that can occur in day-to-day operations to low-probability/high-impact events that can arise through institution-specific and/or systemic market or operational circumstances. A fundamental principle in designing contingency plans is to ensure adequate diversification in the potential sources of funds to be utilized.

In light of the new primary and secondary credit programs, institutions should update existing policies, procedures and contingency plans and remove any reference to the Federal Reserve's former adjustment and extended credit facilities.

Institutions incorporating primary credit into their contingency plans should ensure that they have in place with their Reserve Bank the necessary collateral arrangements and documentation. Management should also occasionally test the institution's ability to borrow at the discount window to ensure there are no unexpected impediments in the process.

Since the Federal Reserve generally expects to extend primary credit on a very short-term basis, usually overnight, institutions should ensure that any use of primary credit facilities is accompanied by viable take-out or exit strategies to replace this funding expeditiously with other sources of funding. Further, given the above-market rates on primary credit, institutions should assess the higher costs of this credit relative to other available sources. Extended use of any relatively expensive source of funds can give rise to supervisory concerns.

Supervisory and Examiner Considerations 

Since primary credit can serve as a viable source of back-up, short-term funds, supervisors and examiners should view the occasional use of primary credit as appropriate and unexceptional. At the same time, supervisors and examiners should be cognizant of the implications that too frequent use of these relatively expensive funds may have for the earnings, financial condition, and overall safety and soundness of the institution. Over-reliance on primary credit borrowings or any one source of short-term contingency funds may be symptomatic of deeper operational and/or financial difficulties.

Information on the new discount window programs, including the revised Regulation A, is available on the Federal Reserve's Web site at www.frbdiscountwindow.org. For more information, please contact your FDIC Division of Supervision and Consumer Protection regional office.

For your reference, FDIC Financial Institution Letters may be accessed from the FDIC's Web site at www.fdic.gov/news/financial-institution-letters/2003/index.html. To learn how to automatically receive FDIC Financial Institution Letters through e-mail, please visit https://service.govdelivery.com/accounts/USFDIC/subscriber/new.

Michael J. Zamorski
Director

Distribution: FDIC-Supervised Banks (Commercial and Savings)

NOTE: Paper copies of FDIC financial institution letters may be obtained through the FDIC's Public Information Center, 801 17th Street, NW, Room 100, Washington, DC 20434 (1-877-275-3342, option 5, or (703) 562-2200).