Bank Rediscounting at the Central Bank: A Survey of Alternative Theories and Some Evidence

Abstract

THE NATURE OF THE RELATIONSHIP between central bank rediscounting policy and the monetary policy transmission process remains controversial. This paper reviews some of the relevant literature on one aspect of this area of monetary economics: the determination of 'commercial banks' rediscounting at the central bank. This is an aspect that has an important impact on the choice of a target variable for monetary policy. Thus, if relative interest rates are the key determinant of rediscounting, and there is no perfect offset between rediscounting and other sources of bank reserves such as open market operations, a targeting system can usefully focus on total bank reserves (e. g., Brunner and Meltzer, 1964). Alternatively, if bank reserves supplied through rediscounting are less expansive in terms of credit and money supply growth than a like amount of reserves supplied through open market operations, the best measure of reserves that banks have to expand the money supply is one that excludes rediscounting (e.g., Roosa, 1959). The paper is organized into four sections. The rest of this section introduces the competing schools of thought that have given rise to different models of bank rediscounting. A number of these models are surveyed in the second part of the paper. The third part of the paper examines some conceptual and empirical problems with the models. In the fourth part of the paper a simple model is introduced in which the competing models discussed in part II can have behavioural content, and this model is tested against data for West German commercial banks over the period 1974-1982. Models of the role of banks' demand for rediscounting tend to be of a rather ad-hoc nature with very little in the way of theory applied to the portfolio choice problem. The usual distinction is between residual and profit theories of rediscounting. Three types of residual theories have been advanced. First, it has been suggested that banks are 'reluctant' to rediscount at the central banki.e. banks are reluctant 1986 SAJE v54 (2) p195 to be in debt to the central bank. Second, it has been suggested that banks only rediscount out of 'need', for example, to meet temporary and unexpected reserve deficiencies. A third view is based on the idea that banks consider the supply of loans as the most important part of their activity, and that they refinance at the central bank to 'accommodate' their customers' loan demands. In each of these hypotheses the central bank is considered as the lender-of-last-resort in the sense that it is the institution to which the commercial banks turn to only when in need of -liquidity. Commercial banks therefore rediscount at the central bank as a result of the constraint imposed by their balance sheet. Rediscounting is thus determined residually and the cost of borrowing is not seen as a variable affecting a bank's portfolio decisions. The second, diametrically opposed, theory is the profit theory of rediscounting. In this view, a bank is a profit-maximizing agent which regards the central bank as a ...

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