The Federal Reserve raises rate on emergency loan program to stop arbitrage
The Federal Reserve has increased the rate on loans to banks issued through its Bank Term Funding Program (BTFP), an emergency lending initiative launched last year. The move comes as borrowing under the program surged recently, with institutions taking advantage of favorable financing terms. The BTFP, introduced during the regional banking crisis to ease stress in the financial system, is set to expire on March 11, as previously indicated by top officials.
Effective immediately, the adjusted interest rate for borrowing under the BTFP will "be no lower" than that of reserve balances in effect on the day the loan is made, according to the Fed. The current rate on reserve balances, which generally aligns with the Fed's benchmark federal funds rate target, is 5.4%. This is higher than the lending program's rate of 4.88%, which is linked to market interest rates that had fallen in anticipation of Fed rate cuts.
The rate adjustment ensures that the BTFP continues to support its objectives in the current interest rate environment, the central bank stated. Other program terms remain unchanged.
The BTFP allows banks and credit unions to borrow funds for up to one year, using US Treasuries and agency debt as collateral valued at par. Prior to the adjustment, the rate for these advances was tied to the one-year overnight index swap rate plus 10 basis points.
Banks have found it more cost-effective to borrow through the BTFP rather than the discount window, which charges eligible institutions 5.5%. The recent change eliminates an arbitrage opportunity for banks that borrowed from the facility before placing the proceeds in their Fed accounts to earn interest on reserve balances.
Fed data showed a record high of $162 billion in borrowing from the BTFP in the week through January 17, surpassing the previous peak of $147 billion in the prior week.
The move is seen as a response to negative press coverage and a real arbitrage opportunity, according to Steven Kelly, associate director of research at the Yale Program on Financial Stability. The Fed aims to avoid being perceived as "printing money" for banks through such mechanisms. While the BTFP was designed to address an emergency situation, Fed officials have highlighted the discount window as a long-term alternative for liquidity needs. Regulators are reportedly considering a plan to require banks to tap the discount window at least once a year to reduce stigma and ensure preparedness for challenging times.