Bank Term Funding Program (BTFP) Explained
The Fed i.e. the central bank of the United States seems to have learned its lesson from the crash of the Silicon Valley Bank. The Silicon Valley Bank was an otherwise healthy bank that had maintained good deposits, made conservative investments, and not given out too many bad loans. The bank had collapsed because of the insolvency caused by temporary cash flow issues.
Silicon Valley Bank had a large amount of high-quality government debt on its balance sheet. They were forced to sell this debt because of the sudden requirement for cash. This debt was valued at below par because the interest rate increases had reduced the value of existing bonds. As a result, the Silicon Valley Bank was forced to realize losses on securities that it had decided to hold till maturity! These losses eroded the equity and eventually caused the bank run.
Hence, if there was a way to temporarily obtain cash against these securities and calm down the depositors, there would not be the need to sell these securities and realize the losses.
The underlying belief is that if Silicon Valley Bank could pay off its depositors once they asked for the money, they would stop suspecting a bank run. If the depositors were confident, the bank could have been saved.
Now, there are a lot of banks that seem to be facing problems similar to Silicon Valley Bank. Hence, if the Fed does not take quick action to somehow manage this problem, it could see several bank failures in the market. This could cause unprecedented panic and endanger the entire banking system.
Central Bank i.e., Lender of Last Resort?
The Silicon Valley Bank failed because it could not obtain funds at the correct time. Once the bank started faltering, the depositors became even more jittery and started withdrawing funds in even large amounts.
In such situations, banks generally approach the interbank lending market to obtain funds. However, even the other banks were skeptical about lending out money to Silicon Valley Bank. This is because they too were afraid that the Silicon Valley Bank might fail and they may not be able to recoup their loans. Even if the banks were willing to lend, they would lend only up to the market value of the securities being used as collateral. In fact, some of them would lend an even lesser amount in order to provide for future interest rate hikes and the subsequent drop in value.
Here, it was important for the Fed to play the role of the lender of last resort. It is the job of the central bank to provide funds to individual banks when all other sources have dried up. However, this should be done only at a high-interest rate. The high-interest rate will ensure that only banks that need to use this facility actually avail of it.
What is Bank Term Funding Program (BTFP)?
The Fed realized that there was a gap in its lending program. A large number of banks were currently holding supposedly risk-free securities such as US treasury notes and government bonds. However, they were unable to obtain funding against the same in order to prevent a Silicon Valley Bank-style bank run. As a result, the Bank Term Funding Program (BFTP) was created in order to provide much-needed liquidity.
The provisions of the Bank Term Funding Program (BFTP) are as follows:
- The Bank Term Funding Program (BFTP) will be available to all depository institutions which are federally insured. This means that all banks, credit unions, and savings associations will be eligible. This also means that US branches of foreign banks will also be eligible to participate in the program
- The Bank Term Funding Program (BFTP) will only lend against highly rated collateral. This means that the program will lend against securities that are used as collateral by the Fed when they undertake open market operations. These securities include US treasuries, US agency securities, and certain high-quality mortgage-backed securities which are backed by US agencies. These securities should have been held by the bank on or before 12th March 2023.
- The Bank Term Funding Program (BFTP) will provide loans against the par value of the security. Hence, the current market value of the security will become irrelevant while making loans. This will ensure that the situation which was faced by the Silicon Valley Bank will not arise again. Had Silicon Valley Bank received par value funding for their debt, they would have been able to manage their bank run and would not have collapsed.
- The loans will be made at an interest rate that would be 10 basis points above the prevailing one-year overnight index swap rate and the maximum tenure available for this loan will be one year. This means that the borrowers will be expected to pay back the loan by the end of the first year. The banks can obviously choose to make a prepayment since there would not be any penalty associated with prepayment.
- Lastly, the Fed has to ensure that the taxpayer does not lose any money while funding these transactions. Hence, the Fed will have full recourse to such loans even beyond the value of the pledged collateral. This means that if the value of the pledged collateral is not enough to cover the loans, the Fed can possess and liquidate other assets of the bank in order to make good its loss.
The Bank Term Funding Program (BFTP) has been created with the intention to provide emergency liquidity to the banks so that they are able to manage any bank run and inspire depositor confidence.
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