If a central bank is to assume the responsibility of being a lender of last resort, it should clearly articulate its objectives in doing so. It should make credible that commitment and act in a way that is consistent with that commitment. It should clearly communicate its lending policies to the public. What’s more, the independence of the central bank’s decision making from short-term political interference is essential to sound policymaking in this arena as well.

There is no inherent conflict They do go together ... I don't think there is a fundamental trade-off. ... [But] while related, they need to be thought about separately.

As reported by Market News International, on whether there is a conflict between the Fed's monetary policy job and its role as lender of last resort, and on the relationship between monetary and policy and financial stability.

The Federal Reserve was created in large part to supply liquidity and calm markets in such situations, importantly by assuring banks of a backup source of funding through the discount window.  To enhance the utility of the discount window and encourage its use, the Federal Reserve reduced the spread between the discount rate and the federal funds rate last August, and we made lending available explicitly on a term basis, rather than only overnight.  However, banks were reluctant to use even this more attractive discount facility because they feared that their counterparties would see it as a sign of weakness, and pressures in term funding markets increased.

In December we introduced a new method for banks to borrow from the Federal Reserve against a broad range of collateral--the term auction facility (TAF).  The TAF is an auction through which a fixed amount of lending is offered to the banking system, and it seems to have been successful in avoiding the "stigma" problem and in helping funding markets return to more normal functioning.  Markets were also aided by coordinated efforts to supply liquidity by several other central banks at the same time.

The changes to the discount window were designed to assure banks of the availability of a backstop source of liquidity. Although banks borrowed only moderate amounts at the discount window, they substantially increased the amount of collateral they placed with Reserve Banks. This and other factors suggest that these changes to the discount window facility, together with the statements and actions of the FOMC, had some positive influence on market conditions.

However, as a tool for easing the strains in money markets, the discount window has two drawbacks. First, banks may be reluctant to use the window, fearing that markets will draw adverse inferences about their financial condition and access to private sources of funding--the so-called stigma problem. Second, to maintain the federal funds rate near its target, the Federal Reserve System’s open market desk must take into account the fact that loans through the discount window add reserves to the banking system... [T]he amounts that banks choose to borrow at the discount window can be difficult to predict, complicating the management of the federal funds rate, especially when borrowings are large.

WSJ: Your bank’s board asked for a quarter point cut in the discount rate before last week’s FOMC meeting. Was that to narrow the penalty over the federal funds rate, or for a parallel move with a presumed reduction in the federal funds rate?

Plosser: It was a little bit of both. A case could have been made for reducing the penalty rate. It was a complicated mixture of what the right strategy should be for the funds rate, the discount rate and the and the term auction facility.

Although the specifics vary across central banks, the approaches outlined have several important common elements. We each have taken actions to provide more financing at terms longer than overnight. We each have chosen to auction funding against a broader range of collateral, collateral other than government securities, and in our case with a broader set of counterparties. And we have activated swap lines to help the relevant central banks provide liquidity in dollars in their markets.

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The Term Auction Facility gives us a tool that lies somewhere between our open market operations and our primary credit program. It provides a mechanism for expanding the range of collateral against which we provide funds to the market—in effect to change the composition of our balance sheet—in ways we cannot do through traditional open market operations.  And it does this in a way that may be more effective in mitigating a broader marketwide liquidity shortage than does the existing discount window facility, in part because of the perceived stigma in recourse to a facility that has come to be regarded as a source of funds for individual institutions facing a temporary, exceptional need for liquidity. Because the quantity of funds to be injected is known in advance, this mechanism poses fewer complications for our ability to reduce volatility in the fed funds rate around the target.

Asked whether the Fed would consider other liquidity measures to stabilize financial markets, such as narrowing the spread in the discount rate, Plosser said "that's certainly something one could entertain."

Plosser acknowledged there was "perhaps a stigma" attached to banks borrowing from the Fed's discount window, which has limited borrowing.  But he said the act of cutting that rate in August itself had a positive effect on markets.

As reported by Dow Jones

...Finally, banks may be worried about access to liquidity in turbulent markets...

This last concern is one that central banks should be able to address.  The Federal Reserve attempted to deal with it when, as I already noted, we reduced the penalty for discount window borrowing 50 basis points in August and made term loans available.  The success of such a program lies not in loans extended but rather in the extent to which the existence of this facility helps reassure market participants.  In that regard, I think we had some success, at least for a time.  But the usefulness of the discount window as a source of liquidity has been limited in part by banks' fears that their borrowing might be mistaken for accessing emergency loans for troubled institutions.  This "stigma" problem is not peculiar to the United States, and central banks, including the Federal Reserve, need to give some thought to how all their liquidity facilities can remain effective when financial markets are under stress. 

[I]t would be wonderful if we could reduce the “stigma” so that it was inconsequential in the borrowing decision. One of our jobs is to act as the lender of last resort. The “stigma” against borrowing from the discount window can interfere somewhat with that.

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We believe that the policy change had an impact, in part, because we witnessed—concurrently—a big increase in the amount of collateral pledged by banks at the window. This indicates that banks did view the window as an important liquidity backstop. Over the past few months, total collateral pledged has climbed by more than $150 billion.

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On August 21, the securities lending fee was lowered to 50 basis points from 100 basis points. This is what we charge primary dealers to borrow Treasury securities from the System Open Market Account. The fee was lowered to encourage greater borrowing of Treasury securities from the Fed’s portfolio in order to ease disruptions in the Treasury bill market. Securities lending did increase and this helped calm the Treasury bill market.

The Federal Reserve's efforts to provide liquidity appear to have been helpful on the whole. To be sure, the volume of loans to banks made through the discount window, though it increased for a time, has been modest. However, collateral placed by banks at the discount window in anticipation of possible borrowing rose sharply during August and September, suggesting that some banks viewed the discount window as a potentially valuable option.

Loans through the discount window differ from open market operations in that they can be made directly to specific banks with strong demands for liquidity.  (In contrast, open market operations are arranged with a limited set of dealers of government securities.)  In addition, whereas open market operations typically involve lending against government securities, loans through the discount window can be made against a much wider range of collateral, including mortgages and mortgage-backed securities.  As with open market operations, however, Fed lending through the discount window provides banks with liquidity, not risk capital. In particular, the strong collateralization accompanying discount window credit eliminates essentially all risk for the Federal Reserve System and the taxpayer. Nonetheless, the availability of the discount window is potentially significant for banks, as it gives them greater confidence that they can obtain additional liquidity as necessary. Access to a backstop source of liquidity in turn reduces the incentives of banks to limit the credit they provide to their customers and counterparties.

For emerging-market economies, the most prominent international institution to act as a lender of last resort has been the International Monetary Fund (IMF). However, demand for IMF lending has dropped more than 80 percent since 2005 as emergency lending has almost ceased and most borrowers have repaid their loans. Such developments have led some to speculate that an international lender of last resort is no longer needed.  

However, it would be naïve to think that we will never again see situations where an international lender will be indispensable.  

When a systemic financial crisis occurs, the emergency lender's most crucial task is to restore confidence in the financial system...  Speed is critical. Experience shows that the faster the lending, the lower the amount of lending necessary.³

To illustrate the benefits of acting quickly, I will use a canonical example, the Federal Reserve's operations in the aftermath of the stock market crash in October 1987. What is remarkable about this episode is that the Federal Reserve did not need to lend directly to the banks to encourage them to lend to the securities firms that needed funds to clear their customers' accounts. ecause the Federal Reserve acted promptly (within a day) and reassured banks that the financial system would not seize up, banks knew that lending to securities firms would be profitable. They saw that making these loans immediately was in their interest, even if they did not borrow from the Federal Reserve. anks thus began lending freely to securities firms, and, as a result, confidence was restored and the fear of crisis diminished almost immediately. The Federal Reserve did not have to increase its lending to the banking system at all, and the actual amount of liquidity that it injected into the banking system through open-market operations in the immediate aftermath of the crash was around $12 billion, which at the time was notable but not exceptional. And the Federal Reserve was able to remove this liquidity almost immediately, within weeks of the crash.

On August 17, the Federal Reserve Board announced a cut in the discount rate of 50 basis points and adjustments to the Reserve Banks' usual discount window practices to facilitate the provision of term financing for as long as thirty days, renewable by the borrower.  The purpose of the discount window actions was to assure depositories of the ready availability of a backstop source of liquidity.