11. Discounts, Discounts, Discounts

“Borrowing at the discount window is essentially a repurchase agreement — pledging collateral in exchange for cash.”

 

This blog article is not on sale, but I am going to explain the "discount mechanism". We are continuing to work with the dealer concept. The dealer was the person that takes the risk on his balance sheet to make transactions possible and receiving a risk premium for that.

I am buying the drinks for my party from the supermarket. Due to the fact that I can not pay for them right now, I make a deal with the supermarket to pay them in 90 days. After 20 days the supermarket realizes that it suddenly needs a lot of money to restock its warehouse. Unfortunately, it only has a “contract” from me that says I am paying him 500 $ in 90 days. It does not have 500$ in cash to buy new drinks from the wholesaler right now and the wholesaler does not accept the contract that the supermarket and I made as a mean of payment. Watson, we have a problem! ;)

Luckily the bank is going to help us out. The bank is willing to “buy” the contract for let’s say 490$ and gives the supermarket 490$ in cash. The bank has enough cash to wait for 90 days. After the 90 days period, I am giving the money to the bank instead of the supermarket and everybody is happy.

That is called to "discount a bill" because the bank gives you money or deposits for your bill, but obviously less money than what the bill is worth because the bank is taking a risk and needs to get paid for that service.

What is a discount rate?

Let’s assume the bank is running out of notes/currency since everyone is taking out money to buy gifts for me. Furthermore, many companies are trying to discount their bills into cash. 

So what can the bank do? 

It can raise the discount rate to discourage people from discounting their bills. If the banks had too many notes they would lower the discount rate to encourage people to discount their bills.

Here is an example. The supermarket has this bill of 500$ and wants to discount it. It goes to the bank across the street. This bank does not have many notes left so they say: 

“We will discount your bill but we take 20 % for that.” 

The supermarket says: “No way, to receive only 400$ is not enough I am going to the next bank!” 

As a consequence, it goes to the bank around the corner. They have many notes so they say: “We only take 10%.” The supermarket is okay with that and walks home with 450 $ in notes. So the discount rate from Bank A was very high to discourage people from discounting their bills there because Bank A is afraid of running out of notes.

What are central banks doing?

Discounts, discounts, discounts  

“Borrowing at the discount window is essentially a repurchase agreement — pledging collateral in exchange for cash.”

This blog article is not on sale, but I am going to explain the "discount mechanism". We are continuing to work with the dealer concept. The dealer was the person that takes the risk on his balance sheet to make transactions possible and receiving a risk premium for that.

I am buying the drinks for my party from the supermarket. Due to the fact that I can not pay for them right now, I make a deal with the supermarket to pay them in 90 days. After 20 days the supermarket realizes that it suddenly needs a lot of money to restock its warehouse. Unfortunately, it only has a “contract” from me that says I am paying him 500 $ in 90 days. It does not have 500$ in cash to buy new drinks from the wholesaler right now and the wholesaler does not accept the contract that the supermarket and I made as a mean of payment. Watson, we have a problem! ;)

Luckily the bank is going to help us out. The bank is willing to “buy” the contract for let’s say 490$ and gives the supermarket 490$ in cash. The bank has enough cash to wait for 90 days. After the 90 days period, I am giving the money to the bank instead of the supermarket and everybody is happy.

That is called to "discount a bill" because the bank gives you money or deposits for your bill, but obviously less money than what the bill is worth because the bank is taking a risk and needs to get paid for that service.

Let’s assume the bank is running out of notes/currency since everyone is taking out money to buy gifts for me. Furthermore, many companies are trying to discount their bills into cash. 

So what can the bank do? 

It can raise the discount rate to discourage people from discounting their bills. If the banks had too many notes they would lower the discount rate to encourage people to discount their bills.

Here is an example. The supermarket has this bill of 500$ and wants to discount it. It goes to the bank across the street. This bank does not have many notes left so they say: 

“We will discount your bill but we take 20 % for that.” 

The supermarket says: “No way, to receive only 400$ is not enough I am going to the next bank!” 

As a consequence, it goes to the bank around the corner. They have many notes so they say: “We only take 10%.” The supermarket is okay with that and walks home with 450 $ in notes. So the discount rate from Bank A was very high to discourage people from discounting their bills there because Bank A is afraid of running out of notes.

 

The central bank is doing the same thing. In the book from Walter Bagehot, it is stated that the central bank should always discount bills or securities from banks to help them fight liquidity problems, but it should do so at a high rate so that the central banks are not losing too many reserves. 

The banks and especially the central banks are using the discount mechanism to balance their balance sheets and protect them from the external drain. Internal drain means that the central bank lends money to one of its members by creating a deposit account for it. External drain means that notes are actually getting out of the system. If money leaves the system, the elasticity gets smaller and the entire system will be tighter. This external drain was especially frightening to the central bank when we still had a gold standard. During that time the money was tied to the value of the gold and if people took gold out of the country, the central bank had less money left to help its own country. 

Therefore they set a high rate for discounting notes into gold, so people would have no incentive to exchange gold and ship it away. We don’t have that gold problem anymore, but we still need some discipline otherwise the banks would take out too much credit. As a result of the central bank having a low discount rate banks are more likely to give their assets (loans, mortgages) to the central bank to get a money for it. They use this money to lend it to someone so they can make a profit. When banks are borrowing money from the central bank they do that using the discount window from the CB.

 

Financial Times Quote: “Borrowing at the discount window is essentially a repurchase agreement — pledging collateral in exchange for cash.” This FT quote summarizes this blog post and the blog post about Repos. As we now know banks have many assets, which they can use as collateral and they make money by getting cheap money and lending it at a higher rate. The two ways they can get money is either through their customers or (especially in a crisis) they can lend from the central bank using their assets as collateral. Due to this discount mechanism the banks can be sure that they can almost always provide liquidity for the market, because they can always use this discount window. 

Introduction

The first article: The hierarchy of money

The second article: Why do we need banks?

The third article: Why we need a central bank?

The fourth article: How can banks create money out of thin air?

The fifth article: Why do we need central banks especially in a crisis?

The sixth article: What are clearing houses?

The seventh article: What are Fed Funds?

The eighth article: What are dealers, brokers and repos?

The ninth article: Quantitative easing and open market operation

The tenth article: Eurodollars

 

The twelfth article:  Why dealers provide liquidity

Written by: Philine Paschen

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