Interbank Rate

Introduction

Interbank rates play a vital role in the global financial system; they represent the rates of interest charged on short-term loans between banks. These rates are pivotal for managing liquidity within the banking sector and have wider implications for various financial instruments and economic conditions.

Key Concepts

Definition

The interbank rate, also known as the interbank lending rate, is the interest rate at which banks lend to each other, typically on an overnight basis. These rates are not directly accessible to individual consumers but significantly influence borrowing and savings rates in the broader economy.

Importance

The interbank rate is crucial for several reasons:

• It helps maintain liquidity in the banking system.
• It serves as a benchmark for other interest rates, including those for mortgages, savings accounts, and loans.
• It reflects the health of the banking sector and overall economic conditions.
• It influences monetary policy and central banks’ decisions regarding interest rates.

Types of Interbank Rates

LIBOR (London Interbank Offered Rate)

LIBOR historically was one of the most used globally and served as a benchmark for an array of financial instruments. It represented the rates at which major global banks borrowed from one another. However, due to various scandals and manipulations, LIBOR is being phased out and replaced.

SONIA (Sterling Overnight Index Average)

SONIA is an interest rate benchmark for sterling-denominated derivatives and other financial contracts. It measures the average of overnight interest rates paid by banks in the sterling market.

EONIA (Euro Overnight Index Average)

EONIA represents the overnight interest rate for the eurozone. It’s calculated as a weighted average of all overnight unsecured lending transactions in the interbank market by a panel of contributing banks.

Federal Funds Rate

In the United States, the Federal Funds Rate is the interest rate at which depository institutions trade federal funds with each other overnight. It is a key tool of monetary policy implemented by the Federal Reserve.

Euribor (Euro Interbank Offered Rate)

Euribor rates are calculated as the average interest rate at which a panel of European banks lend to one another. It serves as a reference rate for various financial products in the eurozone.

TIBOR (Tokyo Interbank Offered Rate)

TIBOR serves as Japan’s interbank lending rate benchmark. It reflects the economic conditions and interbank lending practices in the Japanese market.

Other Notable Rates

• SHIBOR (Shanghai Interbank Offered Rate)
• HIBOR (Hong Kong Interbank Offered Rate)
• SIBOR (Singapore Interbank Offered Rate)

Calculation Methods

Quoted vs Effective Rates

• Quoted Interbank Rate: The advertised rate between banks, often involving verbal or written agreements.
• Effective Interbank Rate: The actual rate realized in transactions, which can vary from the quoted rate due to various factors like risk premium and liquidity.

Contributing Banks

For most interbank rates, a panel of contributor banks provides data based on their lending activities or estimations. This data is then aggregated, eliminating outliers, to compute an average rate.

Calculation Process

1. Collection of Data: Banks submit their interest rates daily.
2. Filtering: Outlying rates may be excluded to avoid distortions.
3. Averaging: The remaining rates are averaged to produce the daily rate.

Historical Evolution

• The concept of interbank rates has evolved with financial markets.
• LIBOR began in the 1980s and became the predominant benchmark.
• Post-Global Financial Crisis reforms emphasized creating more transparent and reliable benchmarks, leading to new rates like SONIA and SOFR (Secured Overnight Financing Rate).

Regulatory and Compliance Aspects

Oversight

Different interbank rates are overseen by various regulatory bodies:

• LIBOR was overseen by the ICE Benchmark Administration.
• Euribor is regulated by the European Money Markets Institute (EMMI).
• Federal Funds Rate is administered by the Federal Reserve.

Scandals and Reforms

The LIBOR manipulation scandal highlighted vulnerabilities and led to major reforms, emphasizing the need for reliable and transparent benchmarks. These reforms include:

• Enhanced oversight and governance.
• Transitioning to new benchmarks like SOFR.
• Reducing reliance on theoretical estimates in favor of transaction-based data.

Applications in Financial Markets

Loans and Mortgages

• Many adjustable-rate mortgages (ARMs) and personal loans are directly tied to interbank rates.
• Changes in interbank rates quickly influence the rates consumers pay on their loans.

Derivatives

• Derivatives like interest rate swaps, futures, and options often rely on interbank rates as benchmarks.
• Accurate benchmarks are crucial for pricing these financial instruments.

Bonds and Fixed-Income Securities

• Corporate bonds and government securities often use interbank rates for setting coupon rates.
• A rise or fall in interbank rates can affect bond yields and prices.

Impact on Monetary Policy

Central banks monitor interbank rates as part of their monetary policy toolkit. Adjustments to policy rates, such as the Federal Funds Rate or the European Central Bank’s main refinancing operations rate, directly influence interbank rates, which in turn affect the broader economy.

Transmission Mechanism

1. Policy Rate Change: Central bank alters the policy rate.
2. Interbank Rate Adjustments: Banks adjust their interbank lending rates accordingly.
3. Impact on Banking Sector: Changes flow through to loan and deposit rates.
4. Economic Influence: The broader economy feels the effects through changes in credit availability and cost of borrowing.

Case Studies and Examples

Global Financial Crisis (2008-2009)

• During the crisis, interbank lending froze, and rates spiked.
• Central banks had to intervene massively with liquidity provision and rate cuts.

LIBOR Scandal

• Major banks were found to have manipulated LIBOR submissions to profit from trades.
• Resulted in billions in fines and a significant overhaul of the interbank rate setting process.

Covid-19 Pandemic

• Central banks acted quickly to keep interbank rates low to support economies.
• Both traditional rate cuts and unconventional measures, like asset purchase programs, were used.

Conclusions

Interbank rates are essential for the functioning of the global financial system. They serve as benchmarks for various financial products, influence monetary policy, and are indicators of economic health. Understanding the dynamics of interbank rates is crucial for financial professionals, regulators, and policymakers.

Sources:

• Bank of England, SONIA: https://www.bankofengland.co.uk/markets/sonia-benchmark
• Federal Reserve, Federal Funds Rate: https://www.federalreserve.gov/monetarypolicy/openmarket.htm
• European Central Bank, EONIA: https://www.ecb.europa.eu/home/html/index.en.html
• ICE Benchmark Administration, LIBOR: https://www.theice.com/iba/libor
• European Money Markets Institute, Euribor: https://www.emmi-benchmarks.eu/euribor-org/euribor-rates.html