Rediscount

Rediscount can refer to either of two concepts in finance: discounting a debt instrument for a second time or a method of providing financing to a bank. More Detailed Explanation: When a lender borrows $1000 from a bank, and promises to pay $100 per month for the next year, the written promise given to the bank is called the "debt instrument". The bank will get $1200 in return for paying out cash of $1000 right now, so it receives the debt instrument at a DISCOUNT. Now suppose for some reason the bank needs to raise cash. It can sell this note (worth $1200 over the year) for any lesser amount, thereby RE-DISCOUNTING the original loan note. A particular form of this occurs when the bank borrows from the Central Bank using this note (debt instrument) as a collateral for the loan. This is also called re-discounting.

Discounting a second time

Rediscount is the act of discounting a short-term negotiable debt instrument for a second time. Banks may rediscount these short-term debt securities to assist the movement of a market that has a high demand for loans. When there is low liquidity in the market, banks can generate cash by rediscounting short-term securities.[1]

Rediscount lines can also be subsidized and this is usually attributed to the following reasons:

  1. an incentive must be offered to financial intermediaries to induce them to lend for purposes that they would otherwise not lend for;
  2. the target sector or group is often judged to need subsidized funding in order to develop.[2]

Financing for a bank

Rediscount is a way of providing financing to a bank or other financial institution. Especially in the 19th century and early 20th century banks made loans to their customers by "discounting" the customer's note. The note is a paper document, in a specified form, where the borrower promises to repay a certain amount at a specified date.

Let's say the customer wants to borrow $1000. The bank may ask him to sign a note promising to repay $1100 in one year. The bank is "discounting" the note by paying less than the $1100 face amount. The extra $100 is of course the bank's compensation for paying before the note matures. The Federal Reserve System could provide financing by "rediscounting" this note. Maybe the Fed would give the bank $1050 for the note.

Rediscounting was once the primary means by which banks obtain loans from the Federal Reserve bank but, at present, most banks turn to this process by discounting their own notes, which - in turn - are secured by the government securities or other eligible paper.[3]

Central bank rediscount procedures can affect demand for public instruments because the case of rediscounting government paper lowers the cost of public debt service on account of the fact that investors - in this condition - are more willing to accept lower level yield.[4]

A central bank's rediscount to commercial banks can be classified into the following:

  • adjustment rediscount: assists banks in addressing the issues of temporary insufficient liquidity and short positions (very short term)
  • seasonal rediscount: used to ease liquidity pressures on banks due to seasonal changes
  • extended rediscount: used to assist banks experiencing drastically decreased deposits or in case of a severe liquidity crunch (long-term)[5]
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References
  1. "Rediscount Definition". Investopedia.
  2. Norton, Roger (2004). Agricultural Development Policy: Concepts and Experiences. Hoboken, NJ: John wiley & Sons, Ltd. p. 327. ISBN 0470857781.
  3. Downes, John; Goodman, Jordan (2010). Dictionary of Finance and Investment Terms. New York: Barron's Educational Series. pp. 588. ISBN 9780764143045.
  4. World bank (1999). European Union Accession: The Challenges for Public Liability Management in Central Europe. Washington, D.C.: The International Bank for Reconstruction and Development/The World Bank. p. 65. ISBN 0821343521.
  5. Xingyun, Peng (2015). Financial Theory: Perspectives From China. Hackensack, NJ: World Century Publishing Corporation. p. 510. ISBN 9781938134319.


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