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Lombard rates are interest rates charged by a central bank to smaller lending institutions for loans, which are then passed on to borrowers. The rates are usually set slightly above the standard interest rate and are used to encourage central government lending during periods of financial instability. Critics argue that the system threatens the sovereignty of private companies.
Lombard rates are the interest rates charged to banks for credit usually provided by a central government. In the most basic sense, Lombard rates are set for the repayment of loans offered by a central bank to smaller lending institutions. These banks are supplied with capital which they in turn lend to other borrowers, opening up credit in the market. To take advantage of the repayment requirement, the central bank charges an interest rate to the bank that is passed on to the borrower, generating revenue for the bank. The guarantee comes in the form of financial securities and life insurance policies issued by the bank itself.
Lombard rates are usually set by the central government or bank slightly above the standard interest rate. For example, if the money rate is set to five percent, the Lombard credit rate is set to six percent. The central bank charges the smaller bank six percent interest on the loan, while the smaller bank turns around and charges the borrower ten percent. This means that the bank is making a profit, hedging against losses in securities, and leverages these securities for the loan. It pays back the loan at a low interest rate or is forced to supply the securities to the central bank.
The two countries most recognized for working with the Lombard credit system are Germany and the United States. In Germany, the central bank issues loans to many financial institutions to preserve the economy by extending credit to businesses. Within the United States, this is maintained by the Federal Reserve System, a group of private banks that work for the government. Both systems lend to institutions at lower rates than what other banks will lend to each other.
During periods of financial instability, the Lombard rate method is used in conjunction with discount rates set by the central government or bank. If the discount rate is set at four percent, then the Lombard rate is set just below this number. This encourages central government lending rather than other banks. Unfortunately, when the discount interest rate settles near zero, as is the case in extreme recessions, the Lombard rate almost becomes a moot point. Loans maintain almost the same cost from the central bank or private banks.
Critics of the system point out that the reliability of the federal government or the central bank is a threat to the sovereignty of private companies. When governments intervene within a country’s financial sector, it is no longer involved with the economy. The balance between the central bank as the “lender of last resort” and as the primary lender in the financial sector is a delicate balance between the free market system and the economic control of a central authority.
Smart Asset.
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