The interbank market is a money market that facilitates commercial and noncommercial banks and other nonbank financial intermediaries to lend and borrow to each other. It consists of two tiers: the lending market and the foreign exchange market, which are the biggest and best known over-the-counter financial markets. Unlike the stock market, the interbank market has no physical exchange, and the transactions do not represent any security being traded. Instead, the transactions conducted in the interbank market purely reflect the participants’ preferences at the prevailing rate. Also, the interbank market plays a crucial role in the determination of monetary policy.
Banks that have a surplus of funds enter the interbank lending market and lend money to banks that are short of funds. The rate at which banks lend to each other is the London Interbank Offer Rate (LIBOR), which serves as a benchmark for short-term interest rates globally. Since the interbank rate closely monitors the interest rates charged by the biggest institutions, it closely reflects the real interest rate being used by the most prominent market participants.
The interbank rates are maintained and published by the British Bankers’ Association (BAA). The BAA maintains a reference panel of banks across a number of countries and institutions; it daily surveys the market activity of the most prominent banks and institutions and classifies their quotes in quartiles. The middle quartiles at which banks lend and borrow are averaged and the resulting rate is the BBA LIBOR rate, which is published in 10 currencies (pound sterling, U.S. dollar, Japanese yen, Swiss franc, Canadian dollar, Australian dollar, euro, Danish kroner, Swedish krona, and New Zealand dollar).
The interbank market is predominantly a short-loan market, with loans ranging from overnight to periods up to six months. The bulk amount of loans, however, is settled overnight. The interest rates charged on the loans is linked to LIBOR plus a margin. So, the loans have the following format: “LIBOR + ¼” or “LIBOR + 10 basis points.” While the LIBOR rate constitutes the “sell” side of the interbank market, the London Interbank Bid Rate (LIBOR) constitutes the “buy” side of the market; thus it represents the deposit rate offered by banks to other banks. Similarly, the Japanese Bankers’ Association publishes the Tokyo Interbank Offered Rate (TIBOR) and the European Banking Federation publishes the Euro Interbank Offered Rate (EURIBOR), which is the benchmark rate at which Euro interbank deposits are offered. EURIBOR is computed as an average of the quotes provided by 57 of the most active banks in the eurozone. It was first published on December 30, 1998. EURIBOR, however, should not be confused with EUROLIBOR, which is the LIBOR rate quoted in euros.
In the United States, the interbank rate is called the “Federal Funds Rate.” The Federal Funds Rate is the rate at which banks and other institutions lend money to each other. However, the mechanism for the Federal Funds Rate is slightly different than the one that prevails in other interbank markets. So, in the U.S. interbank market, banks lend to each other by lending available balances at the Federal Reserve. When banks issue loans, the minimum reserve requirements that should be deposited at any time in the Federal Reserve fall, and the rate at which banks with a surplus of available deposits at the Federal Reserve lend to banks with reserve requirements is called the Federal Funds Rate.
The interbank rate, and accordingly the interbank market, plays a very important role in monetary policy, where an interbank rate target is in essence also a monetary policy target. There is strong correlation between the interbank rate and the rate at which banks borrow from central banks. So, when banks find themselves in need of funds, they can either borrow from other banks at the interbank market and at the prevailing interbank rate or they can instead borrow from the central bank at its rate of interest. Loans offered at the interbank market can mature overnight, while the loans offered by central banks have a minimum maturity of one week. So, provided there is sufficient supply of loans at the interbank market, banks will prefer to borrow at the interbank rate. Yet, if loans are scarce at the interbank market, the interbank rate will increase and banks will have to look for other money alternatives.
The foreign exchange market is also an interbank market where banks can exchange currencies on a 24-hour basis. The foreign exchange market attracts the largest volume at the most competitive quote of any financial market. The market is self-regulated and depends solely on competitive pressures. Transactions in the foreign exchange market can be at the “spot/current,” “forward/future,” or “swap” price. A swap transaction involves a simultaneous purchase and sale of given amounts of foreign currency. Banks in the foreign exchange market use two forms of quotations when trading foreign currency: The first form states the number of units of foreign currency that are needed to buy one unit of the domestic currency. The second form states the number of units of the domestic currency that are needed to buy one unit of the foreign currency.
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