Interbank Lending Markets and Repurchase Agreements

Banks have to lend money in accordance with the amount of reserves that they have on hand. However, there is no way of finding out the exact amount of loans that a bank can give out while still complying with the reserve requirements because taking deposits and making loans happen simultaneously. Therefore, it is impossible to maintain an exact percentage between two dynamically changing numbers.

This is because reserve requirements are calculated as a percentage of their demand deposits. Demand deposits are by definition random. Also banks do not wait to first get all their deposits to make their loans. This would not be feasible. In reality, banks make loans and accept deposits simultaneously. Hence, it is possible that an individual bank may make more or less loans than they should have.

For instance, consider that a bank realizes that it has made so many loans that it now has only 9% of its deposits held as reserves, whereas the required rate is 10% whereas another bank realizes that it is left with 11% of its deposits as reserves, when the required rate is only 10%.

To help banks transfer the surplus and deficit amongst one another, interbank lending markets exist. In this article, we will study about the interbank lending markets in more detail.

The System as a Whole Always Balances

To understand why interbank lending is important, one must first understand the nature of the banking system.

The banking world functions as one united system. Therefore, an individual bank may possibly make excessive loans as compared to the amount it has on deposits. On the other hand, an individual bank may possibly make fewer loans than it should have made. However, the system as a whole would have made the exact amount of loans as prescribed by the reserve requirement percentage.

Hence, the excess reserves held by one bank can be used by other banks to offset their deficient reserve requirements. This will ensure that the system always balances as a whole. To facilitate this transfer of funds between banks, interbank lending markets are required.

Holding Excess Reserves is Pointless

Another point to be noted is that it is not the best interest of the banks to hold on to additional reserves. This is because they do not get paid interest for parking their funds with the Fed. Hence, banks want to minimize the amount that they keep with the Fed.

Hence, if the reserve requirement is 10%, every bank wants to maintain exactly 10% with the Fed and not a penny more! Thus, the interbank lending market always finds willing parties on both sides. Borrowers are willing because the system mandates their willingness whereas lenders have a financial motive to not hold on to the excess funds that they have.

What are Interbank Markets ?

Interbank markets, as the name suggests, are markets where banks deal with other banks. The amount of money that is being borrowed in this market is huge. Also, the sole purpose of borrowing in such markets is to meet the statutory reserve requirements that have been set by the central bank.

Apart from the loans being of huge amounts, they are generally offered without any collateral and for an extremely short duration of time. The average interbank loan is for overnight purposes. Loans of more than one week are unheard of in the interbank markets.

These markets provide banks with the liquidity required to make loans without being constantly worried about deposits. In case, they fall short on deposits, they can always borrow them. Thus, the interbank enable the functioning of the entire market as a well oiled machine.

Repurchase Agreements

Repurchase agreements are an alternative to borrowing in the interbank market. When banks do not want to borrow from each other, they can also borrow from the central bank. In such cases, the central bank usually lends money via a repurchase agreement or a repo.

A repo basically means that a bank sells some of its securities to the central bank with a future contract to buy it back at a slightly higher price. The difference between the two prices becomes the effective interest on the loan.

The central banks usually publish their repo rates from time to time to enable the banks to choose between borrowing from them or borrowing from the interbank market.

Credit Freeze

The borrowing and lending between banks is a very important component of the banking system. When the interbank market and/or repo market stops operating, chaos breaks loose. Such a situation happened in 2008 after the collapse of Lehman Brothers. Banks were scared of counterparty risks that would arise because they were not sure of the financial health of the other institutions. As a result, the interbank market completely froze.

Since the interbank market froze, banks also had to stop making loans because they were not sure if they could meet the reserve requirements. This led to the banking system to come to a grinding halt plunging the world into a recession and increasing scares of systemic failure.