Interbank Rate
The interbank rate is the interest rate at which banks lend to and borrow from one another on a short-term basis, typically overnight or for a few days. It represents the cost of short-term liquidity in the banking system and serves as a reference for many other interest rates across the economy.
How it works
- Banks must maintain enough cash to meet daily withdrawals and regulatory reserve requirements. When a bank has a shortfall, it may borrow from other banks; when it has excess cash, it may lend it out.
- These interbank loans are usually unsecured and short-term, so the interbank rate reflects the market price of immediate liquidity among highly creditworthy institutions.
- The interbank rate is determined in the market by supply and demand among banks, but central banks influence it by setting policy targets and using tools such as open market operations and the discount window.
- Changes in the interbank rate affect overall liquidity: lower rates make borrowing cheaper for banks and generally stimulate lending and economic activity; higher rates tend to tighten credit conditions.
Role of the central bank
Central banks do not directly fix the interbank rate for every transaction but they:
– Announce target ranges or a target rate they want market rates to track.
– Use policy tools (e.g., open market operations, standing facilities, reserve requirements) to steer the interbank rate toward that target.
– Provide emergency liquidity when necessary to stabilize short-term funding markets.
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Interbank rate vs. consumer rates
- The interbank rate is available only to large, highly rated financial institutions and is typically the lowest borrowing cost in the market.
- Consumer and commercial loan rates (mortgages, credit cards, business loans) are based on the interbank rate plus additional spreads that reflect credit risk, term, and the lender’s costs and profit margin.
- Retail customers exchanging currency or buying foreign cash also do not receive the wholesale interbank foreign-exchange rate; providers add a markup or spread.
Interbank rate in foreign exchange
In foreign exchange markets, the term “interbank rate” refers to the wholesale exchange rate at which banks trade currencies with one another. These rates:
– Are continually updated during market hours and are used by banks to manage currency and interest-rate exposure.
– Serve as the reference rate in currency converters and large institutional FX transactions.
– Differ from retail exchange rates because intermediaries add margins or fees for conversion services.
Practical example
- If the interbank lending market is quoting roughly 1.5% for overnight funds, a bank that borrows at that rate and then lends to a less creditworthy borrower might charge the borrower a higher rate (for example, interbank + spread), reflecting credit risk and operational costs.
- Similarly, when converting currency, a bank may transact at the interbank FX rate for large volumes but offer retail customers that rate minus a visible or invisible spread.
Key takeaways
- The interbank rate is the short-term interest rate on loans between banks and the wholesale FX rate between financial institutions.
- It is market-determined but guided by central-bank policy tools and targets.
- It functions as a benchmark: other borrowing and deposit rates in the economy are quoted as the interbank rate plus a premium.
- Retail customers and smaller firms cannot access interbank rates directly and will pay higher rates or face spreads on FX transactions.
Understanding the interbank rate helps explain how central-bank policy translates into everyday borrowing and saving costs, and why quoted retail rates move when monetary conditions change.