What it means
Banks in the United States keep reserve balances (money held in accounts at the central bank) to settle payments and meet requirements. At the end of the day some banks have more than they need and others have less, so they lend to one another.
Most of this lending is overnight, but some banks want certainty for longer. A term federal funds loan fixes the amount, the rate and the repayment date in advance, so the borrower knows its funding cost and the lender knows when the cash returns.
The rate for a term loan is usually higher than the overnight rate when markets expect rates to rise, and lower when they expect rates to fall. For that reason term rates are often read as a signal of what the market expects the central bank to do next.
Treasury teams in banks use term borrowing to smooth their funding. Rolling overnight loans every day exposes a bank to the risk that funding becomes scarce or expensive on a particular day, whereas a term loan removes that risk for the agreed period.
Because the loans are unsecured, lenders look closely at the borrower's strength and set limits on how much they will lend to each counterparty (the other party in a deal). Non-bank businesses do not normally take part, but the rates matter to them because bank funding costs feed into the loans and deposits that companies use.
Pricing is also shaped by the length of the loan and by the day it falls on. Around month-end and quarter-end, demand for funding tends to rise, and term rates that span those dates can carry a premium.
Traders therefore compare the rate for a given period with the overnight rate expected over the same period.
In practice
Real-world examples.
Example
A regional bank expects heavy loan demand next month and wants to secure funding at a known price. Its treasurer borrows $80,000,000 for 30 days from a larger bank. The interest cost is fixed at the start, so the loan pricing team can set rates with confidence. He compares quotes from three lenders before agreeing a price.
Example
A large bank has surplus reserves that it does not need for a few weeks. Rather than lend overnight at a rate that may fall, it lends $200,000,000 for 14 days to a trusted counterparty. It locks in a return and reduces the effort of rolling the loan every day. Her credit team first checks the limit it has set for that borrower.
Example
A financial journalist compares the one-month term rate with the overnight rate and finds the term rate is noticeably higher. She writes that traders expect borrowing costs to rise soon. The gap becomes part of her market commentary for business readers. The article also notes that the term rate is only an indicator, not a promise.
Formula
Calculation
Interest = principal x annual rate x days / 360
A bank borrows $50,000,000 for 30 days at an annual rate of 4.50%.
Interest = 50,000,000 x 0.045 x 30 / 360
Interest = 2,250,000 x 30 / 360 = $187,500
The bank repays 50,000,000 + 187,500 = $50,187,500 on the due date.Case study
Seen in the real world.
Riverbend Savings Bank is an illustrative, fictional institution that relied on overnight borrowing to fund a growing book of small business loans. One quarter-end, overnight funding became scarce and the bank paid a much higher rate than usual for a single night.
The treasurer decided that the bank should not depend on the market's mood each evening. She began borrowing $40,000,000 for 30 days at a time from several counterparties, spreading the maturities so that no single day required a large refinancing.
The extra cost of term borrowing was small, around a few thousand dollars a month, but the bank avoided a repeat of the scramble. The illustrative lesson is that term funding is a form of insurance against a sudden spike in short-term rates. The bank's board later asked for a quarterly report showing the spread between term and overnight borrowing costs, so that the benefit could be tracked rather than assumed.
Watch out
Common mistakes.
- Assuming term federal funds are secured by collateral, when they are normally unsecured loans based on trust in the borrower. The risk is that if the borrower fails, the lender has no pledged assets to sell, which is why limits and credit checks matter.
- Confusing the rate on a term loan with the official policy target, when the term rate is negotiated and reflects market expectations. The policy target guides overnight rates, whereas a term loan is priced between the two banks.
- Treating a term loan as the same as overnight borrowing that is rolled over, which carries refinancing risk each day. Rolling overnight loans can mean paying very different rates on different days.
Questions
People also ask.
Who can lend or borrow term federal funds?
Mainly banks and certain other institutions that hold reserve balances at the central bank.
Why would a bank pay more for a term loan?
It may accept a higher cost in return for certainty that the money will be there for the whole period. Rolling overnight can be cheaper on average, but it leaves the bank exposed to a sudden spike in rates.
How is the interest calculated?
Usually on an actual-days over 360 basis, so the interest equals principal times rate times days divided by 360. The day-count basis is written into the loan confirmation, so both sides calculate the same figure.
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