DEFINITION of Lending Facility
A lending facility is a mechanism that central banks use when lending funds to primary dealers (i.e. banks, broker/dealers or other financial institutions, who are approved to conduct business with the U.S Federal Reserve).
Lending facilities provide financial institutions with access to funds in order to satisfy reserve requirements, using the overnight lending market. Central banks may also use lending facilities to increase liquidity over longer periods, such as by using term auction facilities.
BREAKING DOWN Lending Facility
A lending facility is a source of funds that can support financial institutions in asking for additional capital. A lending facility can provide liquidity at moments of need and can involve various assets to secure the loan. As noted above many financial institutions may tap into lending facilities when they need additional capital to maintain their targeted reserve requirements.
Reserve requirements are what banks must hold in cash against their customers’ deposits. The Federal Reserve's Board of Governors sets the requirement, along with the interest rate they pay banks on their excess reserves. This is according to the Financial Services Regulatory Relief Act of 2006. This rate of interest on excess reserves also serves as a proxy for the federal funds rate.
Banks must secure their reserve requirements in proprietary vaults or at the closest Federal Reserve Bank. The U.S. Federal Reserve (or Fed's) board of governors set reserve requirements. It is one of the three main tools of monetary policy — the other two tools being open market operations and the discount rate.
Lending Facility and Term Auction Facility
The Federal Reserve uses term auction facilities (or TAF) as part of its monetary policy to help increase liquidity in the U.S. credit markets. TAF allows the Federal Reserve to auction fixed amounts of collateral-backed short-term loans to depository institutions (savings banks, commercial banks, savings and loan associations, credit unions) that are in strong financial condition.
According to a press release from the Federal Reserve System Board of Governors in 2007, TAFs are implemented with the express purpose of addressing "elevated pressures in short-term funding markets."
History and Development of Lending Facilities
Lending facilities originated to enhance efficiency when depository institutions required capital. Central banks often accept a variety of assets as collateral from financial institutions in exchange for supplying the loan. These lending facilities can take the form of term auction facilities as noted above: term securities lending facilities, treasury automated auction processing systems (TAAPS), or the overnight lending market.