Interbank market is one of the segments of the money market in which the banking institutions are the parties, and the short-term financial instruments and interbank deposits in the national and foreign currency are transacted. This market is considered as the most important part of the money market. This is the market in which banks have the possibility of lending to each other their liquid assets. It is also a closed market as the transactions in financial instruments can be carried out only by the commercial banks and Central Bank. The brokers act as the intermediaries in this market and for this they receive commissions. Benefits obtained by the commercial banks through the interbank market are:
- The increase of the degree of independence from the refinance credit of the Central Bank
- Possibility of speculation in the financial instruments of this market, as an additional source of the income,
An interbank deposit is a transaction which involves the receipt or grant of one bank to another of a specified amount of cash, with a pre-determined date and interest rate. There are two kinds of interbank deposits:
- Short-term - these are deposits with a maturity period ranging from one day to one month (overnight O/N, tomorrow next T/N, spot next S/N)
- Long-term - the maturity period of these deposits ranges from one month to one year.
The price of an interbank deposit is its interest rate, which is determined by the following factors:
- Interest rates set by the Central Bank (base rate)
- The money supply and demand
- Reliability of the counterpart on the interbank market, (measured by credit risk).
The most popular are the LIBOR (London Interbank Offered Rate), and LIBID (London Interbank Bid Rate) rates. On international financial markets, these rates serve as a reference for determining the prices of various financial instruments.
The types of interbank markets
There are two types of interbank market:
- interbank market with the transactions in pounds sterling,
- interbank market for foreign exchange transactions.
Examples of Interbank market
- Interbank deposits – Banks use Interbank deposits to lend and borrow funds to each other. These deposits are usually short-term in nature, with maturities ranging from one day to one year.
- Interbank lending – Banks often lend to each other for a variety of reasons, such as when one bank needs to make a large payment and doesn't have enough funds to cover it.
- Treasury bills – Treasury bills are short-term debt instruments issued by the government, which banks buy and sell on the interbank market.
- Certificates of Deposit (CDs) – CDs are short-term debt instruments issued by banks and other financial institutions, which are bought and sold on the interbank market.
- Repurchase Agreements (Repos) – Repos are short-term agreements between two parties, in which one party sells securities to the other with the agreement to repurchase them at a later date. Repos are often used as a source of short-term funding by banks on the interbank market.
- Foreign Exchange (FX) – Banks often trade foreign currencies on the interbank market in order to hedge their foreign currency exposure or to speculate on currency movements.
Advantages of Interbank market
The Interbank market provides a number of advantages to commercial banks, including:
- Access to Liquidity: The interbank market provides banks with access to a larger pool of liquid assets than they would have through individual deposits, allowing them to more easily manage their liquidity needs.
- Balance Sheet Management: By participating in the interbank market, banks can manage their balance sheets more efficiently and increase their profitability.
- Risk Management: Banks can use the interbank market to manage their credit risk exposure.
- Diversification: The interbank market allows banks to diversify their portfolios and reduce risk.
- Price Discovery: By participating in the interbank market, banks can gain insight into market pricing, allowing them to make better-informed investment decisions.
- Hedging: Banks can use the interbank market to hedge against foreign exchange and interest rate risks.
- Transparency: The interbank market is highly transparent, allowing banks to better understand the market dynamics.
Limitations of Interbank market
- The interbank market is subject to some limitations. These include:
- The lack of transparency in the transactions due to the lack of a central exchange and market makers. This makes it difficult for market participants to get a fair price for their instruments.
- The counterparty risk, due to the lack of a central exchange, can lead to losses if the counterparty defaults.
- A lack of liquidity in the interbank market can lead to high transaction costs and delays in completing trades.
- The interbank market is also subject to regulatory and legal restrictions, which can limit the types of transactions that can be conducted.
- The interbank market is vulnerable to manipulation, as it is relatively small and not well-regulated.
- The interbank market is subject to the same risks as other markets, such as interest rate risk, currency risk, and credit risk.
- The interbank market is highly cyclical, with periods of high demand and low demand, making it difficult to maintain liquidity.
- One approach related to Interbank market is the use of repurchase agreements. A repurchase agreement is an agreement between two parties wherein one party agrees to sell a security to another party, with the agreement that it will buy the security back at a later date for a higher price. This type of agreement provides banks with the ability to obtain short-term liquidity and allows them to manage their liquidity and capital position more effectively.
- Another approach related to Interbank market is the use of derivatives. Derivatives are financial instruments that are derived from underlying assets, such as stocks, bonds, and commodities. Derivatives allow banks to hedge their risk and protect themselves from fluctuations in the market. Banks can also use derivatives to speculate on the direction of the market, allowing them to increase their profits.
- The third approach related to Interbank market is the use of money market instruments. Money market instruments are short-term, low-risk investments that are typically issued by governments or corporations. These investments typically have maturities of one year or less, and are used by banks to manage their liquidity and capital requirements.
To sum up, the Interbank market is an important part of the money market, allowing commercial banks to lend and borrow liquid assets from each other. Banks can use repurchase agreements, derivatives, and money market instruments to manage their liquidity and capital position, and to hedge their risk and speculate on the direction of the market.
- Allen, F., Carletti, E., & Gale, D. (2009). Interbank market liquidity and central bank intervention. Journal of Monetary Economics, 56(5), 639-652.
- Cocco, J. F., Gomes, F. J., & Martins, N. C. (2009). Lending relationships in the interbank market. Journal of Financial Intermediation, 18(1), 24-48.
- Giannone, D., Lenza, M., Pill, H., & Reichlin, L. (2012). The ECB and the Interbank Market. The Economic Journal, 122(564), F467-F486.