Understanding The Interbank Rate
The interbank rate is the interest rate charged on short-term loans made between U.S. banks. These loans help banks manage their liquidity needs—borrowing money when liquidity is short and lending money when there is excess cash on hand. This interbank lending system is generally short-term, typically overnight, and rarely extends beyond a week.
Interestingly, the term interbank rate is also used to describe the interest rate banks charge each other during wholesale foreign currency transactions.
Key Points
- The interbank rate, also known as the federal funds rate, is the interest charged on short-term loans between financial institutions.
- It can also refer to the foreign exchange rates paid by banks when trading currencies with other banks.
- These rates are typically the lowest available at any given time, reserved for the largest banking institutions.
How the Interbank Rate Works
Federal regulations require that banks hold enough cash reserves to accommodate daily customer withdrawals. These liquidity demands are usually balanced by borrowing to cover any shortfall and lending to earn modest interest on any surplus.
The interest rate earned on these transactions is based on the current federal funds rate, often referred to as the interbank rate or the overnight rate. Notably, this rate is not directly set by the Federal Reserve but is influenced by the one rate the Fed does set—the discount rate. While the Federal Reserve aims to maintain the federal funds rate within a specific target range, the actual rate is determined by banks engaged in these transactions.
The federal funds rate serves as a critical tool for the Federal Reserve, enabling it to adjust overall cash availability in the economy. A lower rate encourages banks to borrow more readily, whereas a higher rate discourages borrowing.
Historical Context
In the economic crisis of 2008, which led to the Great Recession, the Federal Reserve slashed the target range for the federal funds rate to between 0% and 0.25%, maintaining it for seven years to stimulate borrowing and investment. This range gradually increased to 2.25% to 2.5% by December 2018. In response to the 2020 economic crisis, rates were once again reduced to nearly 0%.
This interbank rate is exclusively accessible to the largest, most creditworthy financial institutions. While consumers cannot directly benefit from near-zero rates, all borrowing or savings interest rates are influenced by the core federal funds rate. Thus, loan rates—for mortgages or credit cards, for example—are based on this fundamental rate plus an added premium.
The Interbank Rate in Foreign Exchange
The term interbank rate also holds significance in the interbank market, a global market used by financial institutions to buy and sell foreign currencies. Here, the interbank rate or the interbank exchange rate represents the current value of one currency compared to another. These rates fluctuate constantly by tiny fractions during market hours.
Primarily, banks engage in this trading to manage their own exchange rate and interest rate risks. They may also trade on behalf of substantial institutional clients.
The interbank rate displayed when comparing currencies in online calculators represents this rate. However, consumers won’t receive the actual interbank rate during currency exchanges. Instead, they get the interbank rate plus a premium, which accounts for the exchange company’s profit.
Related Terms: Federal Reserve, discount rate, forex market.
References
- Federal Deposit Insurance Corporation. “FDIC Law, Regulations, Related Acts”.
- Federal Reserve Bank of St. Louis-Economic Research. “Federal Funds Effective Rate”.
- Board of Governors of the Federal Reserve System. “Policy Tools—The Discount Window and Discount Rate”.
- Board of Governors of the Federal Reserve System. “Policy Tools—Open Market Operations”.
- OFX. “What Is the Market Rate?”
