Question

What impact does the existence of the overnight interbank market have on the level of settlement balances held by the commercial banks? Briefly explain.

Answer 1

The inter-bank lending market is a market in which banks extend loans to one another for a specified term. Most inter-bank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the inter-bank rate (also called the overnight rate if the term of the loan is overnight). A sharp decline in transaction volume in this market was a major contributing factor to the collapse of several financial institutions.

Banks are required to hold an adequate amount of liquid assets, such as cash, to manage any potential bank runs by clients. If a bank cannot meet these liquidity requirements, it will need to borrow money in the inter-bank market to cover the shortfall. Some banks, on the other hand, have excess liquid assets above and beyond the liquidity requirements. These banks will lend money in the inter-bank market, receiving interest on the assets.

Role of inter-bank Market/Lending

1) Inter-bank loans are important for a well-functioning and efficient banking system. Since banks are subject to regulations such as reserve requirements, they may face liquidity shortages at the end of the day. The inter-bank market allows banks to smooth through such temporary liquidity shortages and reduce 'funding liquidity risk'.

2) Interest rates in the unsecured inter-bank lending market serve as reference rates in the pricing of numerous financial instruments. These benchmark rates are also commonly used in corporate cash flow analysis as discount rates.

3) Funding liquidity risk captures the inability of a financial intermediary to service its liabilities as they fall due. This type of risk is particularly relevant for banks since their business model involves funding long-term loans through short-term deposits and other liabilities. The healthy functioning of inter-bank lending markets can help reduce funding liquidity risk because banks can obtain loans in this market quickly and at little cost.

3) For the interest rate channel of monetary policy to work, open market operations must affect the overnight federal funds rate which must influence the interest rates on loans extended to households and businesses. The interest rate channel of monetary policy refers to the effect of monetary policy actions on interest rates that influence the investment and consumption decisions of households and businesses.

As discussed above, the existence of the overnight inter-bank market have strong impact on the level of settlement balances held by the commercial banks.