Interbank Market

The interbank market or interbank loan market is a market in which banks lend themselves to each other over a certain period of time. Most interbank loans are made with a maturity of one week or less, being the majority of a day. These loans are made at the interbank rate. The low volume of transactions in this market was one of the main factors that contributed to the financial crisis of 2007.

Banks are required to maintain an adequate amount of liquid assets, such as cash, in order to cope with potential banking panics of their customers. If a bank can not meet these liquidity requirements, it will need to borrow money in the interbank market to cover the overdraft. Some banks, on the other hand, have excess liquid assets above liquidity requirements. These banks will lend money in the interbank market, receiving interest on their borrowed assets.

Interbank interest rate

The interbank rate is the interest rate charged on short-term loans between banks. Banks lend and borrow in the interbank market to manage their liquidity and comply with regulations such as the cash ratio. The interest rate charged depends on the availability of money in the market, the current rates and the specific terms of the contracts, such as the expiration time. There is a broad set of interbank rates that are published and are fundamental since they are the reference indices of many loans or loans, including mortgage loans for the purchase of housing.

  • Euribor, interbank interest of the euro (eurozone) (a group of countries in Europe)
  • Federal funds rate (United States)
  • LIBOR (United Kingdom)

Role of the inter-bank loan in the financial system

Support for the fractional reserve banking model

The creation of credit and the transfer of the funds created to another bank creates the need for a bank "net lender" to borrow and that can cover the discoveries derived from compliance with the liquidity requirements. This is a consequence of the fact that the initially created funds have been transferred to another bank. If there were (hypothetically) only a commercial bank, then all the new credit (money) created would be redeposited in that bank (or kept as physical cash out of it) and the need for interbank loans for this purpose would be reduced. In any case, in a model of fractional reserve banking it would still be necessary to answer the question of a banking panic.

A source of funds for banks

Interbank loans are important for the proper functioning and efficiency of the banking system. Since banks are subject to regulations such as the reserve ratio, they can face situations of liquidity shortages at the end of the day. The interbank market allows banks to soften the temporary lack of liquidity and

Reference for short-term loan types

The unsecured interbank market interest rates serve as reference rates for assigning prices to numerous financial instruments, such as floating rate notes (FRNs), adjustable-rate mortgages (ARMs) and syndicated loans. These reference rates are also frequently used in corporate banking cashflow analysis, such as the analysis of discount rates. Therefore, the conditions in the interbank market can have wide effects on the financial system and the real economy by influencing the investment decisions of companies and households.

Transmission of monetary policy

The central banks of many economies implement their monetary policy by manipulating instruments that allow them to achieve a certain value for an operational objective. Instruments are defined as the variables directly controlled by a central bank, such as the cash ratio, the interest rate paid on funds borrowed from the central bank, and the structure of the balance sheet. Operating objectives are a typical measure of bank reserves or short-term interest rates such as the overnight interbank rate. These objectives are set in such a way that a specific policy is achieved, which will vary among central banks according to their specific mandate.

Tensions in interbank lending markets during the 2007 financial crisis

By mid-2007, cracks began to happen in the markets for asset – backed securities (better known by its English name, "asset-backed security" and its acronym ABS). For example, in June 2007, the rating agencies lowered the note around 100 bonds backed by subprime mortgages. Shortly thereafter, the investment bank Bear Stearns liquidated two hedge funds that had invested heavily in mortgage – backed securities (better known by its English name, "mortgage-backed security" and its acronym MBS) and several mortgage lenders were declared bankrupt. Tensions in the interbank lending markets became evident on August 9, 2007, once the French bank BNP Paribas announced that it was going to stop paying the returns of three of its investment funds. That morning, the Libor dollar rate rose more than 10 basis points (bps) and remained high thereafter. The Libor-OIS spread soared to around 90 basis points in September, when it had averaged 10bps in the previous months.

During the next meeting of the Federal Reserve Board on September 18, 2008, the Fed began to relax its monetary policy aggressively to respond to problems in the financial markets.

By the end of 2007, the Federal Reserve had cut the target rate for the Fed's financing by 100bps and launched several programs to facilitate liquidity to the market, without preventing the Libor-OIS differential from remaining high. During most of 2008, term financing conditions remained under pressure. In September 2008, when the US government decided not to rescue the investment bank Lehman Brothers, the credit markets went from being in tension to completely breaking down and the Libor-OIS differential burst to over 350bps.

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