Why Standing Facilities Matter
A central bank can influence overnight interest rates not only by changing its policy stance or conducting market operations, but also by standing ready to accept deposits from eligible institutions or lend to them. These arrangements are called standing facilities because eligible institutions can generally use them at the stated terms when they need to, rather than waiting for a central-bank market operation.
A deposit facility offers a place for eligible institutions to hold overnight funds and receive interest. A lending facility provides overnight funds to eligible institutions, typically against acceptable collateral. Together, their administered rates can anchor the rates institutions are willing to accept or pay in the overnight market. The bounds are not automatic guarantees: access rules, collateral, limits, costs, and market frictions matter.
These rates are annualized quotations, not the dollar amount earned or paid over one night. To calculate overnight interest, the annual rate must be combined with the principal and the day-count convention. For example, under a simple ACT/360 convention, one day's interest on principal \(B\) at annualized rate \(r\), written as a decimal, is \(B r/360\). The convention should be stated rather than assumed.
How the Facilities Put Bounds on Market Rates
The deposit facility gives an eligible institution with surplus funds an alternative to lending those funds overnight in the market. If a market borrower offers less than the deposit rate, the institution can prefer depositing at the central bank. This substitution tends to discourage eligible lenders from accepting a lower market return, so the deposit rate can act as a floor.
The lending facility gives an eligible institution that needs overnight funds an alternative to borrowing from another institution. If a market lender charges more than the central-bank lending rate, the borrower can prefer the facility, assuming it has sufficient eligible collateral and can access the facility in time. This substitution tends to discourage eligible borrowers from paying a higher market rate, so the lending rate can act as a ceiling.
This inequality describes an idealized rate-bound argument, not a law that every observed market quotation must obey. It assumes relevant institutions can access the facilities without binding quantity constraints, can transact at the stated rates, and face no material additional cost or delay. It also assumes that the market and facility transactions are sufficiently comparable in timing, risk, and settlement. If these assumptions fail, a market rate can fall below the deposit rate or rise above the lending rate.
Deriving the Rate-Bound Argument
The floor follows from comparing two uses of the same overnight funds. Suppose an eligible institution has one unit of funds and can either lend it in the market at \(r_M\) or deposit it at the central bank at \(r_D\). If both choices have comparable risk and no extra cost, the market loan is less attractive whenever \(r_M < r_D\). The institution can switch to the deposit facility instead. Thus, in the idealized case, a market rate below \(r_D\) creates an incentive for lenders to withdraw funds from the market, which pressures the market rate upward.
The ceiling follows by comparing two sources of overnight borrowing. If an eligible institution can borrow at the central bank for \(r_L\), it will not choose a comparable market loan at a higher rate \(r_M > r_L\). Borrowers can instead use the facility, reducing their willingness to borrow in the market at the higher rate and pressuring that rate downward. Therefore the two substitution arguments give \(r_D \leq r_M \leq r_L\) under the stated assumptions.
The reasoning is about incentives at the margin. It does not mean every institution uses a facility, or that the market rate must equal either facility rate. Institutions may trade with one another at rates inside the bounds because their alternatives, counterparties, and costs differ.
Worked Example: Corridor Width and One-Night Interest
A central bank pays 3.80% on overnight deposits and charges 4.60% on overnight loans. An eligible institution places $12,000,000 in the deposit facility for one night. A second institution borrows $5,000,000 from the lending facility for one night. Use simple ACT/360 interest. Find the corridor width and each institution's one-night interest.
Method. Subtract the facility rates to obtain the corridor width. Then convert each annualized rate to a decimal and multiply by principal and the one-day fraction \(1/360\).
The width is \(4.60\%-3.80\%=0.80\) percentage points. Since one percentage point is 100 basis points, the width is \(0.80 \times 100=80\) basis points.
For the deposit, the annual rate as a decimal is \(0.038\). Its one-night interest is:
Rounded to cents, the institution earns $1,266.67. For the loan, the annual rate is \(0.046\):
Rounded to cents, the borrowing institution pays $638.89. The results are consistent with the rates: the lending facility rate is higher than the deposit facility rate, and the one-night interest amounts are far smaller than a full year's interest.
Common mistake avoided: The corridor width is 0.80 percentage points, not 0.80 basis points. Also, dividing by 360 is appropriate here only because the problem specifies ACT/360.
Limits, Eligibility, and Frictions
Facility rates influence market choices only when institutions can actually use the facilities. A central bank may restrict access to specified counterparties, require acceptable collateral for lending, set limits on amounts, or impose operational deadlines. An institution without direct access may need to use an intermediary, which can charge a fee or decline to pass through the full facility rate.
Other frictions include settlement risk, counterparty credit risk, balance-sheet costs, and the inconvenience of arranging a transaction. For example, a market loan may be unsecured while a central-bank loan requires collateral. The facility rate alone does not describe the full economic cost of the two choices. As a result, a rate slightly outside the corridor need not be an arbitrage opportunity: it may reflect an access barrier or a difference in transaction risk or cost.
A quantity limit can also make a bound apply to only part of an institution's funds or funding need. The institution may use the facility up to its limit, then place or borrow the remaining amount in the market. In that case, the facility still affects incentives, but it does not set the return or cost on every dollar.
Worked Example: A Deposit Limit and a Market Rate Below the Facility Rate
An eligible institution has $10,000,000 to place overnight. Its deposit facility pays 3.60%, but the institution may deposit no more than $6,000,000 there. It places the remaining $4,000,000 in the market at 3.20%. Use simple ACT/360 interest. Find total one-night interest and the annualized return on the full balance.
Method. Calculate interest separately for the facility balance and the market balance, add the amounts, and then annualize the total using the same ACT/360 convention.
The facility portion earns:
The market portion earns:
Rounded to cents, market interest is $355.56. The total is \(\$600.00+\$355.56=\) $955.56. To find the annualized return on the full $10,000,000 balance, reverse the one-day ACT/360 calculation:
The result is a weighted average of 3.60% on 60% of the funds and 3.20% on 40%: \(0.60(3.60\%)+0.40(3.20\%)=3.44\%\). It is below the deposit facility rate because the institution cannot deposit the full balance there. This is not a contradiction of the ideal floor argument; the quantity-limit assumption does not hold for the full amount.
Common mistake avoided: Applying the 3.60% facility rate to all $10,000,000 ignores the limit. The correct calculation separates the amount eligible for the facility from the amount placed in the market.
Comparing Facility and Market Choices
For an institution with access, comparing the quoted rates is a useful first step. The relevant comparison is not simply whether the market rate is higher or lower; it is which alternative is available for the amount and transaction in question. A market lender compares its net return with the deposit facility. A market borrower compares the market borrowing cost with the lending facility, including any collateral and operational requirements.
| Institution's position | Facility alternative | Rate incentive in the idealized case |
|---|---|---|
| Has overnight funds to place | Deposit at \(r_D\) | Less reason to lend in the market below \(r_D\) |
| Needs overnight funds | Borrow at \(r_L\) | Less reason to borrow in the market above \(r_L\) |
| Cannot access the facility or has reached its limit | No usable alternative for that amount | The facility rate may not bind the market choice |
Keep the direction of each comparison straight. A potential lender cares about the return on funds, so the deposit rate is the relevant floor. A potential borrower cares about the cost of funds, so the lending rate is the relevant ceiling. Facility rates therefore act as a backstop and an outside option; they are not, by themselves, a complete explanation of the market rate.
Common Errors and Exam Traps
- Reversing the bounds. The deposit rate is the potential floor because it is an alternative return for lenders. The lending rate is the potential ceiling because it is an alternative cost for borrowers.
- Confusing percentage points and basis points. A difference of 0.80 percentage points equals 80 basis points, not 0.80 basis points.
- Using the wrong day-count denominator. Use 360 only when ACT/360 is specified. A different convention changes the one-night cash amount.
- Assuming universal access. A facility rate is not a practical outside option for an institution that is ineligible, lacks collateral, faces a binding limit, or cannot complete the transaction in time.
- Calling every out-of-corridor rate an arbitrage. Before making that claim, check that the same institution can access the facility for the same amount, over the same period, with comparable risk and no material extra costs.
Check Your Understanding
For each problem, state any comparison or calculation needed before interpreting the result.
- A central bank pays 3.25% on overnight deposits and charges 4.00% on overnight loans. Calculate the corridor width in percentage points and basis points. Then calculate one-night deposit interest on $9,000,000 under simple ACT/360. (Answer: 0.75 percentage points, or 75 basis points; $812.50)
- An eligible institution can place $18,000,000 overnight either in a market paying 4.15% or in a deposit facility paying 4.30%. Under simple ACT/360, how much interest does it forgo in one night by choosing the market? Assume equal risk and no transaction costs. (Answer: $75.00)
- An eligible borrower can borrow $24,000,000 for one night at a market rate of 5.25%, or from the central bank at 5.10%. Under simple ACT/360, calculate the one-night saving from using the facility, ignoring collateral and other costs. (Answer: $100.00)
- An institution has $12,000,000 to place overnight. Its deposit facility pays 3.60%, but has a $7,000,000 limit; it places the remaining $5,000,000 in a market paying 3.20%. Under simple ACT/360, find total one-night interest and the annualized return on the full balance. (Answer: $1,144.44 total; 3.4333% annualized)
- A market borrower sees a rate of 4.85%, while the central bank's lending facility charges 4.70%. The borrower is eligible but has only enough acceptable collateral to borrow half the required funds through the facility. Explain why the facility rate does not necessarily cap the rate on the full borrowing. (Answer: The 4.70% facility rate is a usable alternative only for the collateral-supported half; the remaining borrowing may still need to be obtained in the market at 4.85%.)