Lombard rates are the interest rates charged to banks for credit usually supplied 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 capital which they, in turn, lend to other borrowers, opening up credit in the market. To leverage the requirement for repayment, the central bank charges an interest rate to the bank which is passed onto the borrower, creating income for the bank. Collateral comes in the form of financial securities and life insurance policies issued by the bank itself.
Lombard rates are generally set by the central government or bank slightly above the standard interest rate. For example, if the money rate is set at five percent, the Lombard credit rate is set at six percent. The central bank charges the smaller bank six percent interest on the loan, while the smaller bank turns around and charges its borrower ten percent. This means the bank is making a profit, hedging against losses on securities, and leverages these securities for the loan. It repays the loan with the low interest rate or is forced to supply the securities to the central bank.
The two countries most recognized as working with the Lombard credit system are Germany and the United States. In Germany, the central bank issues loans to many financial institutions in order to preserve the economy through making credit available for businesses. Within the United States, this is maintained by the Federal Reserve System, a group of private banks working for the government. Both systems lend to institutions at lower rates than other banks will loan to each other.
During periods of financial instability, the method of Lombard rates are used in conjunction with the discount rates set by the central government or bank. If the discount rate is set up at four percent, then the Lombard rate is set just below this figure. This promotes borrowing from the central government rather than other banks. Unfortunately, when the discount interest rate is set near zero, as is the case in extreme recessions, the Lombard rate nearly becomes a moot point. Borrowing maintains nearly the same cost from either the central bank or private banks.
Critics of the system point to the reliability on the federal government or central bank as a threat to the sovereignty of private business. When governments intervene within the financial sector of a country, it ceases to be uninvolved with the economy. The balance between the central bank as being a “lender of last resort” and being a primary lender in the financial sector is a delicate balance between the free market system and economic control from a central authority.