What is a broker loan?

A broker loan is a type of loan that banks give to securities firms or brokers. The loan is for a short time and the securities firm or broker must pay it back quickly. The securities that the firm or broker buys with the loan money are used as collateral. This means the bank can take the securities if the loan is not paid back.

Key features of broker loans

Broker loans have a few important features:

They are short-term loans, often needing to be paid back in a few weeks or months
The loans are secured by the securities the firm or broker buys with the money
The bank can demand the loan be paid back at any time, usually with one day’s notice
They are also called broker call loans

Why broker loans are used

Securities firms and brokers use these loans to quickly get money to buy securities for their clients. Instead of using their own money, they borrow from the bank. This lets them buy more securities than they could on their own.

The loans are short-term because the firms and brokers plan to sell the securities soon after. They will use the money from selling to pay back the loan.

How broker loans work

The process of getting and using a broker loan goes like this:

The securities firm or broker asks the bank for a loan
The bank and firm or broker agree on the loan amount, interest rate, and when it must be paid
The bank gives the money to the firm or broker
The firm or broker uses the money to buy securities for clients
The securities are used as collateral for the loan
When the firm or broker sells the securities, they use the money to pay back the bank
If the firm or broker does not pay the loan, the bank keeps the securities

The bank can demand payment

A key part of broker loans is the bank can demand payment at any time. The firm or broker usually has 24 hours to pay after the bank asks for the money back. This is why they are sometimes called call loans. The bank can “call” the loan when they want.

The bank might demand payment if:

They think the securities used as collateral are losing value
Interest rates are going up and they can lend the money for more elsewhere
They need the money back for other reasons

This quick demand for payment is a risk for the securities firms and brokers. They must be sure they can pay back fast if needed.

Collateral for broker loans

The securities the firm or broker buys with the loan money are used as collateral. Collateral is something valuable that is legally promised to the bank if the loan is not paid.

How collateral works

For broker loans, the collateral process works like this:

The securities are bought with the loan money by the firm or broker
The securities are then held by the bank
If the loan is paid back on time, the bank releases the securities back to the firm or broker
If the loan is not paid, the bank keeps the securities and sells them

The bank will only give a loan up to a certain percent of what the securities are worth. This is so they can sell the securities for enough money to cover the loan if it is not paid back.

Risks of securities as collateral

Using securities as collateral has risks though. The value of securities can change a lot in a short time, especially during economic problems.

If the value of the securities goes down, the bank may require the firm or broker to give them more securities or pay back some of the loan right away. This is known as a margin call.

If the securities lose too much value, the bank may sell them for less than the loan amount and the firm or broker will owe the difference. This is a big risk for the firm or broker.

Broker loan interest rates

The interest rates on broker loans are often a little higher than other short-term loans. This is because of the risks the bank takes lending money with securities as collateral.

The specific interest rate is determined by:

The current prime interest rate that banks charge their best customers
How risky the securities used as collateral are
How long the loan will be for
The financial strength of the firm or broker borrowing the money

Interest rates can change over the life of the loan as economic conditions change.

Regulating broker loans

Broker loans are regulated by the Federal Reserve in the US. The Fed sets rules such as:

What percent of a security’s value can be borrowed
How the collateral must be held and managed
Required recordkeeping about the loans
Limits on how much of a bank’s money can be in broker loans

These regulations aim to reduce risks to banks and the wider financial system from broker loans.

Broker loan controversies

Broker loans have been blamed for adding to financial crises in the past. During the 1929 crash that started the Great Depression, many broker loans went bad as stock prices crashed.

Banks then demanded payment, which led to more selling and further drops in prices. Some argue this made the crash and depression much worse.

After 1929, more regulations were put on broker loans to try to prevent this from happening again.

Critics say broker loans can still add risk and instability to markets, while defenders argue they are a needed financing option.

Broker loans today

Today, broker loans are still used but are a smaller part of the lending market than in the past. More regulations and alternative financing methods have reduced their role.

Most large securities firms today rely more on other funding like issuing their own bonds or getting long-term loans.

However, broker loans remain an important tool especially for smaller firms needing quick capital. As markets and economies change, the role of broker loans may also shift in the future.