What Is a Lending Facility?

A lending facility is a service offered by a central bank to commercial banks in which short-term loans are made to cover variations in cashflow for the borrowing banks. The rates charged for a lending facility can have a strong indirect effect on the availability and cost of credit to businesses and consumers.

In most countries, banks will often have a need to borrow money for a short period, in many cases overnight. This borrowing is needed because inevitably there will be days when a bank gives out more in loans than it takes in deposits. This can happen even with banks that are, in the long term, very profitable. Because of these variations in cashflow, if banks were not able to make these short term loans, they would need to maintain high cash reserves and would not make any profit from the money kept in these reserves.

These short term loans can be made between two commercial banks, usually through a dedicated market. Those banks that have a daily surplus can lend it overnight to those with a daily shortfall. In many countries, a central bank will make such short-term loans to commercial banks, usually making it the dominant player in this market. Loans from a central bank made in this way are described as a lending facility.

A lending facility may also help satisfy reserve requirements. These are rules that mean that a bank must always hold cash to the value of a fixed proportion of its total loans. This is designed to reduce the likelihood that a bank will be badly hit if some borrowers fail to repay loans.

The rate the central bank charges for the lending facility is often known as the base rate. Due to the fact that this is such an important cost for commercial banks, it can have a strong effect on the rates those banks must charge its own customers, for example mortgage borrowers or business loan customers. It can also have an effect on the rates the bank can pay savers. How closely the base rate affects commercial bank rates depends on how competitive the commercial market is.

In many countries, setting the base rate for the lending facility is considered a key tool of monetary policy. Depending on the country, the base rate is controlled by the government, or by the central bank itself acting independently. The common theory is that a low base rate makes credit more available and can boost investment, though with the constraint that if rates are too low, consumers with mortgages will have higher disposable incomes which can cause inflation.