What Is Bond-for-Bond Lending?

Bond-for-bond lending is a lending structure used in the U.S. Federal Reserve Bank's security lending facility. Borrowers, typically commercial banks, receive a loan of bonds by using all or a portion of their own portfolio of bonds for collateral. The bond-for-bond lending structure is different from the Federal Reserve’s traditional cash for bond lending structure, in which the borrower takes the loan as cash instead.

Key Takeaways:

  • Bond-for-bond lending is a lending structure used in the U.S. Federal Reserve Bank's security lending facility.
  • Commercial banks receive a loan of bonds by using all or a portion of their own portfolio of bonds for collateral.
  • The bond-for-bond lending structure is sometimes preferable to cash loans because it can allow better cash management for the lender.
  • The Federal Reserve lends at a higher rate than the short-term rates that banks could obtain in the market.

Understanding Bond-for-Bond Lending

The bond-for-bond lending structure is sometimes preferable to cash loans because it can allow better cash management for the lender. In fact, to encourage banks to first seek funding from normal market sources, the Federal Reserve lends at a higher rate and is thus more expensive than the short-term rates that banks could obtain in the market under normal circumstances. The Federal Reserve sometimes uses this structure to help minimize the impact on the aggregate level of cash available in the banking system.

Bond-for-Bond Lending to Commercial Banks

The Federal Reserve loans to commercial banks and other depository institutions, which is typically known as discount window lending, to help the banks overcome difficulties they may have in attaining funding. These difficulties can range from common issues, such as funding pressures related to unexpected deviations in a bank's loans and deposits, to extraordinary events, like those that occurred after the September 11, 2001, terrorist attacks or during the 2008 financial crisis.

In all cases, the U.S. central bank provides loans when normal market funding cannot meet the funding needs of commercial banks. Although bond-for-bond lending was not designed to be used as a consistent form of lending during normal market conditions, it is available to cover unforeseen developments.

Why Bond Loans Are More Expensive for Banks

Banks generally prefer to borrow from other banks since the interest rate is cheaper, and the loans do not require collateral. Banks will usually only borrow bonds from the Federal Reserve when they are suffering short-term liquidity shortfalls and need a quick infusion of cash. For this reason, the volume of Federal Reserve bond lending to banks tends to jump considerably during periods of economic distress when all banks are experiencing some degree of liquidity pressure.

For instance, after the dotcom tech bubble burst in 2001, borrowing at the Federal Reserve's discount window hit its highest level in 15 years. To minimize the risk that the Federal Reserve will incur losses from bond-for-bond lending, banks must pledge collateral in the form of bonds from their own portfolios. Since 1913 when the Federal Reserve was established, the central bank has never lost money on its discount window loans, including bond-to-bond loans to commercial banks.