Interbank lending market
The interbank lending market is a market in which banks lend funds to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate (also called the
Banks are required to hold reserves of an adequate amount of
by customers. To remain compliant, those banks with less than the required liquidity will borrow money and pay interest in the interbank market, while those with excess liquid assets will lend money and receive interest.The interbank rate is the rate of interest charged on short-term loans between banks. Banks borrow and lend money in the interbank lending market in order to manage liquidity and satisfy regulations such as
Interbank segment of the money market
The interbank lending market refers to the subset of bank-to-bank transactions that take place in the money market.
The money market is a subsection of the financial market in which funds are lent and borrowed for periods of one year or less. Funds are transferred through the purchase and sale of money market instruments—highly liquid short-term debt securities. These instruments are considered cash equivalents since they can be sold in the market easily and at low cost. They are commonly issued in units of at least one million and tend to have maturities of three months or less. Since active secondary markets exist for almost all money market instruments, investors can sell their holdings prior to maturity. The money market is an over-the-counter (OTC) market.
Banks are key players in several segments of the money market. To meet reserve requirements and manage day-to-day liquidity needs, banks buy and sell short-term uncollateralized loans in the
Role of interbank lending in the financial system
To support the fractional reserve banking model
The creation of credit and transfer of the created funds to another bank, creates the need for the 'net-lender' bank to borrow to cover requirements for short-term withdrawals by depositors. This results from the fact that the initially created funds have been transferred to another bank. If there was (conceptually) only one commercial bank then all the new credit (money) created would be redeposited in that bank (or held as physical cash outside it) and the requirement for interbank lending for this purpose would reduce. (In a
A source of funds for banks
Interbank loans are important for a well-functioning and efficient banking system. Since banks are subject to regulations such as reserve requirements, they may face liquidity shortages at the end of the day. The interbank market allows banks to smooth through such temporary liquidity shortages and reduce 'funding liquidity risk'.
Funding liquidity risk
Funding liquidity risk captures the inability of a financial intermediary to service its liabilities as they fall due. This type of risk is particularly relevant for banks since their business model involves funding long-term loans through short-term deposits and other liabilities. The healthy functioning of interbank lending markets can help reduce funding liquidity risk because banks can obtain loans in this market quickly and at little cost. When interbank markets are dysfunctional or strained, banks face a greater funding liquidity risk which in extreme cases can result in insolvency.
Longer-term trends in banks' sources of funds
In the past,
Benchmarks for short-term lending rates
Interest rates in the unsecured interbank lending market serve as reference rates in the pricing of numerous financial instruments such as floating rate notes (FRNs), adjustable-rate mortgages (ARMs), and syndicated loans. These benchmark rates are also commonly used in corporate cashflow analysis as discount rates. Thus, conditions in the unsecured interbank market can have wide-reaching effects in the financial system and the real economy by influencing the investment decisions of firms and households.
Efficient functioning of the markets for such instruments relies on well-established and stable reference rates. The benchmark rate used to price many US financial securities is the three-month US dollar Libor rate. Up until the mid-1980s, the Treasury bill rate was the leading reference rate. However, it eventually lost its benchmark status to Libor due to pricing volatility caused by periodic, large swings in the supply of bills. In general, offshore reference rates such as the US dollar Libor rate are preferred to onshore benchmarks since the former are less likely to be distorted by government regulations such as capital controls and deposit insurance.
Monetary policy transmission
Central banks in many economies implement
US federal funds market
Interest rate channel of monetary policy
The
As explained in the previous section, many US financial instruments are actually based on the US dollar Libor rate, not the effective federal funds rate. Successful monetary policy transmission thus requires a linkage between the Fed's operating targets and interbank lending reference rates such as Libor. During the 2007 financial crisis, a weakening of this linkage posed major challenges for central banks and was one factor that motivated the creation of liquidity and credit facilities. Thus, conditions in interbank lending markets can have important effects on the implementation and transmission of monetary policy.
Strains in interbank lending markets during the 2007 financial crisis
By mid-2007, cracks started to appear in markets for
At the following FOMC meeting (September 18, 2007), the Fed started to ease monetary policy aggressively in response to the turmoil in financial markets. In the minutes from the September FOMC meeting, Fed officials characterize the interbank lending market as significantly impaired:
“Banks took measures to conserve their liquidity and were cautious about counterparties’ exposures to asset-backed commercial paper. Term interbank funding markets were significantly impaired, with rates rising well above expected future overnight rates and traders reporting a substantial drop in the availability of term funding.”
By the end of 2007, the Federal Reserve had cut the fed funds target rate by 100bps and initiated several
Possible explanations
Increase in counterparty risk
An increase in
The market environment at the time was not inconsistent with an increase in counterparty risk and a higher degree of information asymmetry. In the second half of 2007, market participants and regulators started to become aware of the risks in securitized products and derivatives. Many banks were in the process of writing down the values of their mortgage-related portfolios. House prices were falling all over the country and the ratings agencies had just started to downgrade subprime mortgages. Concerns about structured investment vehicles (SIVs) and mortgage and bond insurers were growing. Moreover, there was very high uncertainty about how to value complex securitized instruments and where in the financial system these securities were concentrated.
Liquidity hoarding
Another possible explanation for the seizing up of interbank lending is that banks were hoarding liquidity in anticipation of future shortages. Two modern features of the financial industry suggest this hypothesis is not implausible. First, banks have come to rely much less on deposits as a source of funds and more on short-term wholesale funding (brokered CDs, asset-backed commercial paper (ABCP), interbank repurchase agreements, etc.). Many of these markets came under stress during the early phase of the crisis, particularly the ABCP market. This meant banks had fewer sources of funds to turn to, although an increase in retail deposits over this period provided some offset.
Second, it has become common for corporations to turn to markets rather than banks for short-term funding. In particular, before the crisis firms were regularly tapping commercial paper markets for funds. These corporations still had lines of credit set up with banks, but they used them more as a source of insurance. After the near collapse of the commercial paper market, however, firms took advantage of this insurance and banks had no choice but to provide the liquidity. Thus, firms’ use of credit lines during the crisis increased illiquidity risks for banks. Lastly, banks’ off-balance sheet programs (SIVs for example) relied on short-term ABCP to operate; when this market dried up, banks in some cases had to take the assets from these vehicles onto their balance sheets. All of these factors made liquidity risk management especially challenging during this time.
Glossary of key interbank lending rates
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United States
Federal funds rate
The federal funds rate is the weighted average rate at which banks lend to each other in the overnight funds market, also known as the US overnight rate. The actual rate is determined daily by market conditions, but the Federal Reserve System uses various methods to influence the rate toward a target range. These include issuing cash in exchange for bonds and paying banks to maintain excess reserves.
US dollar Libor rate
The US dollar Libor rate, short for the London interbank offer rate, is the rate at which banks indicate they are willing to lend to other banks for a specified term. Previously it was the British Banker's Association average of interbank rates for dollar deposits in the London market. However, the administration of the rate has been transferred to the Intercontinental Exchange. Term Libor rates reflect the expected path of monetary policy as well as a risk premium associated with credit and liquidity risks.
Europe
In Europe, the interbank lending rate is called Euribor, published on euribor-ebf website.[4]
Shanghai
In
Hong Kong
In Hong Kong, the interbank lending rate is called HIBOR, published by the Hong Kong Association of Banks.[6]
Australia
In Australia, the overnight interbank lending rate is called the cash rate.
India
In
See also
- Market liquidity
- Liquidity crisis
- Money market
- Libor
- Euribor
- Libor-OIS spread
Notes
1. For example, the Federal Reserve's policy objectives include maximum employment, stable prices, and moderate long-term interest rates whereas the Bank of England's mandate is to keep prices stable and to maintain confidence in the currency.
References
- ^ "2008 Monetary Policy Releases". Federal Reserve. October 6, 2008. Retrieved 2021-03-25.
- ^ Ireland P (2019). "Interest on Reserves: History and Rationale, Complications and Risks". Cato Journal. 39 (2): 327–337.
- ^ "Policy Tools — Reserve Requirements". Federal Reserve. February 3, 2021. Retrieved 2021-03-25.
- ^ "Home". euribor-ebf.eu.
- ^ "Home". shibor.org.
- ^ "Home". hkab.org.hk.
- Afonso, G, Anna Kovner, and Antoinette Schoar (2010), “Stressed, not Frozen: The Federal Funds Market in the Financial Crisis”, NBER Working Paper 15806.
- Angelini, Nobili, and Picillo (2009), “The interbank market after August 2007: what has changed and why?”, Bank of Italy working paper number 731, October.
- Ashcraft, McAndrews, and Skeie (2009), "Precautionary Reserves and the Interbank Market", Federal Reserve Bank of New York Staff Reports, no. 370.
- Cook, Timothy and Robert LaRoche (eds), "Instruments of the money market," Monograph, Federal Reserve Bank of Richmond.
- Federal Reserve Act. Section 2a. Monetary Policy Objectives. http://www.federalreserve.gov/aboutthefed/section2a.htm
- Gorton, G and A Metrick (2009), “Securitized Banking and the Run on Repo“, NBER Working Paper 15223.
- Bank of England. Monetary Policy. http://www.bankofengland.co.uk/monetarypolicy/index.htm Archived 2012-02-05 at the Wayback Machine
- "IMF Global Financial Stability Report April 2008", International Monetary Fund.
- "IMF Global Financial Stability Report October 2008", International Monetary Fund.
- Mester, Loretta (2007). “Some Thoughts on the Evolution of the Banking System and the Process of Financial Intermediation”, Federal Reserve Bank of Atlanta Economic Review.
- Michaud and Upper (2008), "What drives interbank rates? Evidence from the Libor panel", BIS Quarterly Review, March 2008.
- Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. Addison Wesley, 2009.
- Taylor, JB and JC Williams (2009), “A Black Swan in the Money Market”, American Economic Journal: Macroeconomics, 1:58-83.