Lombard credit

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Lombard credit is the granting of credit by banks against pledged items, mostly in the form of securities or life insurance policies. The pledged items must be readily sellable. Lending is via central banks, in particular the securities 'eligible for collateral' which are registered on lists; as a general rule, the Lombard rate (interest rate) is more or less one per cent above discount rate. The pledging of securities means that the credit institutions have the opportunity of acquiring money in the short term from central banks.

One prominent role of "Lombard Credit" is in use by the Federal Reserve System of the United States of America. Traditionally, the Discount Rate, or the rate charged by the Fed to member banks in need of funds (ostensibly to maintain the required reserve ratio), was lower than the target Federal Funds Rate, or the rate charged among banks for the same type of overnight credit. This meant that banks could borrow from the government at a lower rate than they could from each other, which didn't make much economic sense. Since a Central Bank's role (among others) is often to act as a lender of last resort, presumably a bank should only borrow from the Discount window after it has exhausted all other possible sources of funds. If this were really the case, such a loan would actually be more risky than a loan from another bank, thus meriting a higher interest rate. The US was lagging behind many European central banks in this regard, as a Discount Rate lower than the rate typically charged by another bank opened the possibility of arbitrage and thus required extra scrutiny of potential borrowers. Thanks to the work of several bright and influential economists, the Federal Reserve Board of the United States switched to a so-called "Lombard Facility," in which the Discount Rate is actually higher than the targeted Fed Funds Rate, thus creating an economic incentive for banks to look elsewhere before asking to borrow from the Fed.^[1] It is believed that the term "Lombard Facility" refers to the traditional arrangement set forth by the Bank of England.

In the minds of many bank executives and market participants there is still a stigma attached to borrowing from the Discount window, so while the vast majority of Federal Funds loans occur below the Discount Rate (at or near the Target Federal Funds Rate), there have been instances when banks have paid above-market rates (particularly, rates at or even above the Discount Rate) for Federal Funds. Some economists speculate that banks take advantage of this arbitrage opportunity by borrowing from the Fed at the Discount Rate and then loaning that money as Federal Funds to other banks at a higher rate.