Interbank Market - Meaning, Importance and its Functions

The banking system is the bedrock upon which the modern financial system stands.

The banking system is highly integrated with the entire economy. Retail borrowers, small and medium enterprises, large companies as well as governments are all involved in borrowing money from banks at regular intervals. It is for this reason that the well-being of the banking system is considered to be a prerequisite for the well-being of the entire economy.

The interbank overnight credit market (IBOC) often referred to as the interbank market has a very important role to play in the day-to-day functioning of the banking system. This article explains the concept of the interbank market as well as the functions this market performs.

What is Interbank Market?

The interbank market is probably the second largest and second most important sub-market which falls under the money market.

The market for treasury bills is generally considered to be the most important market in almost every economy.

Since the interbank market deals with transactions that have a maturity of less than one year, this market can also be classified as being a part of the money market.

The interbank market is called the interbank market because only banks and other depository institutions participate in this market. The reason behind the existence of the interbank market is the reserve requirement laws.

Central banks want to control the extent of liquidity in any banking system. They do so by ensuring that banks hold a certain amount of funds in reserves. This is essential since banks use short-term deposits to make long-term loans and there is always the risk that there will be a run on the bank.

The reserve regulations ensure that the banking system as a whole has enough liquidity even though individual banks may have more or less liquidity.

The reserve requirements make it mandatory for a bank to hold at least 5% of its deposits as reserves. Now, the problem is that the deposits and liabilities of any bank keep on changing in real-time. Hence, it is impossible to maintain the 5% ratio. It is likely that some banks will have more reserves whereas others will have fewer reserves.

The interbank market is meant to enable the transfer of funds from one bank to another just to meet the reserve requirements. These funds are usually transferred overnight and are transferred back after meeting the regulatory requirement. This is the reason that the bank is called the interbank overnight credit market.

The central bank plays an important role in creating the demand for reserves. The central bank pays an abysmally low-interest rate on excess reserves. Hence, there is no incentive for banks to keep excess reserves locked up with the central bank.

It would be more advantageous for these banks to lend reserves to other banks. Also, if banks do not lend to each other, then they can approach the central bank for funds. The central bank generally keeps this rate higher than the interbank market. Basically, the central bank facilitates transactions between banks by creating a conducive environment.

Functions of the Interbank Market

The interbank market is considered to be an important market since it performs several important functions. Some of these functions have been listed below:

1. Supports Fractional Reserve System: The interbank market is very important since it supports the fractional reserve banking system. If banks cannot borrow reserves from each other, they will be unable to lend money at the same pace and with the same efficiency that they do today.

   The fractional reserve system is very important since it controls the creation of credit in any economy. Control over the creation of credit provides banks with a huge influence over the aggregate demand of any economy. Hence, the interbank market is vital since it not only impacts the banking system but also the overall economy.

2. Benchmarks for Lending Rates: The treasury rates are considered to be benchmarks for lending. However, interbank rates are also widely used for this purpose. In many parts of the world, it is common to express the interest rate as a function of the interbank rate.

   For instance, interest rates are often expressed as LIBOR plus or minus a certain percentage. Hence, once again it can be seen that the interbank market has the potential to affect the larger economy.

3. Reduces Liquidity Risks: The existence of the interbank market leads to a marked reduction in the liquidity risk of the entire banking system. This is because a single bank is much more vulnerable to a run on the bank as compared to the entire banking system.

   The interbank market provides banks with the wherewithal required to face a run on the bank. If investors start rapidly withdrawing money from the bank, it can tap the interbank market to borrow in the short run and make good on its promise. Over time, the borrowers will be convinced about the financial strength of the bank and the entire financial catastrophe will be avoided.

The bottom line is that the interbank market is a vital component of the money markets as well as the economy in general. It performs a very important function for the banking system and also has a large impact on the overall economy.

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