Explainer: The US Federal Reserve’s Bank Term Funding Program

The failure of three large banks this month once again shook the US banking system. To safeguard against more such failures, the Federal Reserve announced the Bank Term Funding Program (BTFP).

This explainer helps us understand the BTF Program.

What is the rationale for the BTFP?

Banks lend for longer-term, illiquid projects whereas the deposits they collect are usually short term and highly liquid. If depositors demand their funds back, the bank has to honour its commitments.

However, banks cannot readily recall their loans. Thus, banks engage in the inter-bank market where they lend/borrow from other lenders to avail of liquidity.

The problems start when one bank fails. When that happens, people worry about the status of their bank and banks start to worry about the status of other banks.

There is a tendency for depositors to rush and withdraw their deposits from banks. Likewise, banks stop lending to each other as they are unsure of getting their money back. When banks are unable to borrow, they cannot pay back depositors.

In such a scenario, central banks have to step in and perform their function of the Lender of Last Resort (LOLR). Under LOLR, central banks should stand ready to provide ample liquidity to banks/financial firms that need it. Otherwise, the bank will become bankrupt as depositors rush to withdraw their funds.

Under LOLR, the central bank should provide funds to solvent banks that are struggling to get liquidity at an interest rate higher than the market interest rate. It should not provide funds to insolvent banks – that would lead to insolvent banks always asking for funds in the future, a problem termed as a moral hazard.

It should also charge a higher interest rate because it is for lending against last resort, when funds are not available. A higher interest rate ensures that only those in high need – and not every entity – avails of the facility.

The Fed designed the BTFP based on LOLR principles. The 2023 banking crisis created concerns for both banks and their depositors. The BTFP is designed to mitigate these concerns and prevent more bank runs.

What is the BTFP?

The Federal Reserve said the objective of the BTFP is “to make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors.”

It stated “the BTFP will be an additional source of liquidity against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress.”

The terms of the BTFP are as follows:

·       Which depository institutions? Any US federally insured depository institution (including a bank, savings association, or credit union) or US branch or agency of a foreign bank that is eligible for primary credit.

·       What are the eligibility criteria? The programme is limited to collateral eligible for purchase by the Federal Reserve in open market operations such as US Treasuries, US agency securities, and US agency mortgage-backed securities. Only highly rated collateral can be used to avail of the facility. This ensures that lending is available to depository firms that have highly rated securities but are unable to get liquidity due to market conditions.

·       How will the securities be valued? The securities will be valued at par and not at market value. This has been done because under difficult market conditions, market prices will be lower and banks won’t get adequate help. The par valuation will help firms to not just get adequate funding but also help them not to sell these securities at a discount.

·       What is the rate for borrowing? The rate for term advances will be the one-year overnight index swap rate plus 10 basis points; the rate will be fixed for the term of the advance on the day the advance is made.

·       What is the term of borrowing? The lending is available for one year and eligible institutions can avail the facility at any time in the period from March 12, 2023, to March 11, 2024. The facility will end in a year unless it is extended by the Federal Reserve.

Will the BTFP help?

The Federal Reserve releases a weekly statement of its balance sheet, disclosing how much funds/reserves it has made available under various programmes. As the programme started on March 12, 2023, the central bank released data for the week ended March 16, 2023, which showed that eligible depository institutions availed average daily funds worth $2.4 billion and the total outstanding till March 15, 2023, was $11.94 billion.

While the amount is tiny compared to other Fed programmes, it has helped some banks when they were failing and there were concerns over getting funds.

If the figures decline or remain constant, it could signal that the crisis has ended. If they rise, it will suggest that banks continue to be under stress.