What it means
Banks sometimes run short of cash overnight or for a few days. A central bank can supply that cash if the bank hands over collateral, which is an asset the central bank can keep if the loan is not repaid.
The interest rate charged on this lending is the Lombard rate. Because banks would normally borrow from each other at a lower rate, the Lombard rate acted as an upper limit.
A bank would use central bank lending only as a last resort, so it set a ceiling above which market rates rarely rose. Together with a lower deposit rate, it formed a corridor around the central bank's main policy rate.
The name comes from the Lombards, the northern Italian merchants and bankers who lent against pledged goods in medieval Europe. Germany and Switzerland adopted the term for central bank lending against securities, and it is still used in some countries.
In the eurozone, the equivalent facility is known as the marginal lending facility, and in other places it may be called the Lombard facility or a similar name. The term has a second meaning in private banking.
A Lombard loan is a loan to a client secured on a portfolio of shares, bonds or funds, and the bank lends only a percentage of the portfolio value. The percentage depends on how risky each asset is, and the bank applies a haircut, which is a discount to the market value of the collateral.
If the portfolio value falls and the loan becomes too large compared with the collateral, the bank issues a margin call, asking the client to add assets or repay part of the loan. Failure to respond can lead to the bank selling the collateral.
Rates on such loans are usually a reference rate plus a margin.
In practice
Real-world examples.
Example
A commercial bank has a temporary shortfall of cash after a large customer withdrawal. It pledges government bonds worth $50,000,000 to the central bank and borrows overnight at the Lombard rate. It repays the next morning when other funding arrives.
Example
A business owner needs $400,000 for a short-term project but does not want to sell her shares. Her private bank offers a Lombard loan secured on her portfolio, lending up to 60% of its value. She pays interest only, and repays when the project completes.
Example
A treasurer at a mid-sized company compares funding costs. He sees that a Lombard loan on the company's securities portfolio costs less than an unsecured overdraft. He negotiates a facility with clear margin call rules.
Formula
Calculation
Maximum loan = Portfolio value x (1 - Haircut)
Annual interest = Loan x Interest rate
A client pledges a portfolio worth $1,000,000, and the bank applies a 30% haircut, so the maximum loan is $1,000,000 x (1 - 0.30) = $700,000. At an assumed interest rate of 4.5%, a full drawdown costs $700,000 x 0.045 = $31,500 a year. If the portfolio then falls by 20% to $800,000, the lending value drops to $800,000 x 0.70 = $560,000. The loan of $700,000 now exceeds the lending value by $700,000 - $560,000 = $140,000, so the client faces a margin call for that amount.Case study
Seen in the real world.
Aldermoor Bank is an illustrative, fictional regional bank that depended on short-term borrowing from other banks. One afternoon, rumours about a large borrower unsettled the money market, and other banks refused to lend to it overnight.
The treasurer pledged $200,000,000 of government bonds to the central bank and borrowed at the Lombard rate, which was higher than normal market rates. The cost was noticeable, but it kept the bank's payments running and avoided any public sign of stress.
Over the following weeks, the bank reduced its reliance on short-term funding and built a larger buffer of liquid assets. The story is illustrative, but it shows why the Lombard rate is both a safety net and a signal: using it is expensive, and banks prefer to avoid it.
Watch out
Common mistakes.
- Assuming the Lombard rate is the main policy rate, when it is usually the higher rate for last-resort lending.
- Treating a Lombard loan from a private bank as risk-free, when a fall in the portfolio can trigger a margin call.
- Ignoring the haircut and assuming a bank will lend the full value of the pledged assets.
Questions
People also ask.
Where does the name come from?
It comes from the Lombards, medieval Italian bankers who lent against pledged goods, and the word has been used in German-speaking countries for central bank lending against securities.
Is the Lombard rate still used today?
The term remains in use in some countries and in private banking, while the euro area uses the name marginal lending facility for its equivalent.
What happens if I cannot meet a margin call on a Lombard loan?
The bank can sell some or all of the pledged assets to repay the loan, which may crystallise losses.
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