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What Is: The Interbank Lending Market?

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The Interbank Lending Market refers to the transactions that occur between financial institutions in money markets. These transactions are usually loans between banks with excess reserves and banks in need of capital, and have maturities of less than one year.

Why Do Banks Loan Each Other Money?

Typically, Interbank Lending occurs for several reasons:

  • Satisfying reserve requirements issued from their central bank
  • Managing day-to-day needs for capital to cover operating costs
  • Increasing reserves to guard against liquidity risks, offest balance sheet liabilities, and protect a bank from insolvency
  • Providing an overleveraged institution with emergency capital to prevent bankruptcy

What Types Of Funds Are Used? 

Interbank loans consist of short-term debt securities, usually instruments that are very liquid and have high yields (dividends made on securities). These debt-securities are widely regarded as cash equivalents due to the prominence of secondary markets for them and their high marketability. Here’s a short list of securities that are commonly used:

  • Certificates of Deposit
  • Repurchase Agreements
  • Commercial Paper
  • Eurodollar Deposit
  • Federal Agency Short-Term Securities
  • Federal Funds
  • Municipal Notes
  • Treasury Bills
  • Money Funds
  • Foreign Exchange Sales
  • Asset Backed Securities

Because of the wide number of markets for these types of products, banks can often sell the pools of assets that they own on the open market before the loans they acquire actually mature. 

How Are These Transactions Processed?

Most uses of the term Interbank Lending refer to the uncollateralized, over-the-counter transactions using federal funds, the deposits in accounts at Federal Reserve banks. When a bank is in need of capital to meet reserve requirements or just to fund their day-to-day expenses, it approaches an institution with excess reserves and depending on the relationship between the two, a transaction is made. The bank with excess reserves loans the bank in need the funds at the interbank rate which is set by their central bank. Note that these funds are pledged without significant or even adequate collateral, so the system of interbank lending is largely based on the confidence that one institution has in the credit-worthiness of another. 

How Important Is Interbank Lending To The Banking System?

The interbank lending market is a critical component of the U.S. financial system, largely because it encourages credit creation and distribution throughout the economy. 

  • Access to credit allows financial institutions to fund their operating costs and satisfy reserve requirements, which are the first lines of defense against bank runs and under capitalization. 
  • The ability to create and extend credit helps banks fund special investment projects and loan money to businesses which helps to promote and support economic growth. 
  • The effective interest rates (the actual rate a lending bank charges to a borrower) applied in the interbank market are used as benchmarks for the rates charged to depositors on contracts like adjustable-rate mortgages or syndicated loans (loans in which a group of banks finances a loan for a single borrower). 

Are There Dangers To Interbank Lending?

One of the primary risks of the interbank lending system is that banks loan each other funds over-the-counter, and the borrowing bank doesn’t have to pledge collateral for the funds it receives. The Federal Reserve only has the authority to use open market operations to influence the interest rates banks charge each other and inject new capital to encourage banks to lend. The loans themselves, which are usually in millions of securities by volume, are othewise conducted with little scrutiny even between parties. The subprime mortagage crisis in 2007-2008 exposed the problems caused by banks that were too heavily indebted to their peers and couldn’t acquire financing enough to open for business. If a bank was believed to be in danger of insolvency or too debt laden, other firms in the sector refused to lend to it and if the Federal Reserve as a lender of last resort refused to intervene with emergency funds, a bank failed. 

Also, there are more risks posed when the Federal Reserve is too accomodating with its interest rate targets. In our previous discussion of the Federal Funds Rate we learned that the Federal Reserve Board doesn’t set a concrete number for the interbank interest rates, but instead decides on an ideal number and pursues monetary policy to bring effective rates as close to that target as possible. To lower the target, the Federal Reserve purchases securities from banks, increasing their excess reserves to encourage lending and investment. But this is problematic when the FED continues this policy for too long a period as banks invest too aggressively and lend too widely, depleting their reserves and making themselves more vulnerable to negative speculation and at greater risk for insolvency. 

Lastly, the transactions cleared in the interbank lending market have far-reaching effects outside of the financial industry. For instance, during the height of the subprime mortgage crisis, acute shortfalls in loans prompted spikes in interest rates on mortgage loan contracts held by consumers as banks attempted to buoy the value of their asset-backed securities. Additionally, corporations and investment firms use the short-term interest rate benchmarks as guidelines for the analyses performed on their own financial positions and as such, their investment decisions are directly impacted by conditions in interbank lending. In general, the efficiency of interbank lending is heavily dependent on a stable benchmark interest rate, since the interest rate will impact the value of the securities traded between private and central banks. Benchmark rates can be impacted by a variety of factors like government regulations or manipulation by private institutions. 

Anything Else We Should Know?

Interbank lending is an essential part of our financial system, and is one the primary mechanisms banks use to remain capitalized so that they can continue to lend. It is good to keep track of the Fed Funds Interest Rate, particularly if you’re a business owner in need of capital. Lower rates flush banks with excess reserves making lending easier, so in theory acquiring capital should be easier when the Fed decides to lower it targets for interbank rates. 

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About Alexander J Smith III