What Is a Lending Facility?

A lending facility is a mechanism that central banks use when lending funds to primary dealers such as 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. They generally accomplish this by using term auction facilities.

How Lending Facilities Work

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 a loan. As noted above, many financial institutions may tap into lending facilities when they need additional capital to maintain their targeted reserve requirements.

Lending facilities can provide liquidity when required.

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 Fed's board of governors are the ones who set reserve requirements. The reserve requirement is one of the three main tools of monetary policy—the other two tools being open market operations and the discount rate.

Lending Facility vs. Term Auction Facility

The Federal Reserve uses term auction facilities (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.

TAFs are implemented with the express purpose of addressing "elevated pressures in short-term funding markets," according to the Federal Reserve System Board of Governors.

Key Takeaways

  • Central banks use lending facilities when lending funds to banks, broker-dealers, or other financial institutions approved to conduct business with the U.S Federal Reserve.
  • These facilities provide financial institutions with access to funds in order to satisfy reserve requirements.
  • They provide liquidity when needed and can involve various assets to secure a loan.
  • Lending facilities come in the form of term securities lending facilities, treasury automated auction processing systems, or the overnight lending market.

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 the following term auction facilities: Term securities lending facilities, treasury automated auction processing systems (TAAPS), or the overnight lending market.

Term securities lending facilities (TSLF) were run by the Fed's open market trading desk, and started as weekly lending facilities. The TSLF lets primary dealers borrow U.S. Treasury securities for 28 days by putting up eligible collateral. The Fed created the TSLF in 2008 so it wouldn't have to affect currencies or securities prices while easing the credit market for Treasury securities.

TAAPS is a computer system developed and run by the Fed to process bids received for Treasury securities that trade through the auction process. Prior to the automated system being put into place in 1993, the Fed received bids in paper form.

The overnight lending market, on the other hand, help banks meet their reserve requirements. Banks that have more than the requirement at the end of the day lend to banks that fall short. These funds are kept at the Fed or in the receiving bank's vault.