I document the erosion of the historic restriction, at least since the 1930s, of Federal Reserve discount window assistance to liquidity-strained banks on the security of sound assets. Section 1 deals with lending operations from the founding until the post World War II period, during which loans to nonbanks first occur. I then discuss Federal Reserve actions in recent decades that have further blurred the distinction between liquidity and solvency, and also the emergence of various nonbanks as candidates for discount window assistance. I ask why these developments have occurred when there has been no change in official declarations of commitment to supply only liquidity, not solvency or capital, to individual banks, not nonbanks (section 2). In the next section I examine the costs of Federal Reserve support for problem institutions that regulatory authorities eventually close and for nonhanks that would otherwise have to meet a market test (section 3). Finally, I consider whether reforms of discount window practices that have been proposed could remedy the inherent problems of the mechanism. I comment on provisions in the FDIC Improvement Act of 1991 that may be worthy reform proposals but do not address these problems (section 4). I offer my conclusions in section 5.
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