Pledging Requirement

What is Pledging Requirement?

Pledging Requirement refers to a legal, or bureaucratic, stipulation that marketable and actively traded securities be pledged as collateral for public fund, or other specific, deposits.

Understanding Pledging Requirement

Pledging banks usually keep pledged securities in some sort of separate account. These securities can be held by many different institutions, such as an independent trustee or Federal Reserve Bank. They can then serve as collateral for deposits made by local and state governments as well as the federal government. Treasury securities are usually pledged at full face value, while banker's acceptances and commercial paper are taken at 90% of their face value.

Banks must pledge securities when they borrow from the Federal Reserve's discount window. The discount window is a central bank lending facility meant to help commercial banks manage short-term liquidity needs. The Federal Reserve and other central banks maintain discount windows, referring to the loans they make at an administered discount rate to commercial banks and other deposit-taking firms. Discount window borrowing tends to be short-term – usually overnight – and collateralized. These loans are different from the uncollateralized lending that banks with deposits at central banks do among themselves. In the U.S., these loans are made at the federal funds rate, which is lower than the discount rate.

According to frbdiscountwindow.org, the following types of instruments can used to satisfy pledging requirements:

• Obligations of U.S. government agencies and government-sponsored enterprises
• Obligations of the United States Treasury
• Obligations of states or political subdivisions of the U.S.
• Collateralized mortgage obligations (CMO)
• Asset-backed securities (ABS)
• Corporate bonds
• Money market instruments
• Residential real estate loan
• Commercial, industrial, or agricultural loans
• Commercial real estate loans
• Consumer loans.

The full value of the loan needn't be pledged. The Federal Reserve discount window has a 'Payment System Risk Collateral Margins Table' that

"includes collateral margins for the most commonly pledged asset types. Assets accepted as collateral are assigned a collateral value (market value or estimate multiplied by the margin) deemed appropriate by the Federal Reserve Bank. The financial condition of an institution may be considered when assigning values."

The pledging of collateral is one reason why banks generally prefer to borrow from other banks since the rate is cheaper, and the loans do not require collateral. But the discount window is an important lender of last resort when the financial system is under stress. Every financial institution knows it can raise cash immediately in the case of a liquidity crunch or crisis.