What Is the Interbank Rate? Definition, How It Works, and Example

What Is the Interbank Rate?

The interbank rate is the rate of interest charged on short-term loans made between U.S. banks. Banks may borrow money from other banks to ensure that they have enough liquidity for their immediate needs, or lend money when they have excess cash on hand. The interbank lending system is short-term, typically overnight, and rarely more than a week.

The term interbank rate also refers to the interest rate charged when banks conduct wholesale transactions in foreign currencies with banks in other nations.

How the Interbank Rate Works

Banks are required by federal regulators to hold enough cash in reserve to accommodate day-to-day withdrawals from their customers. These liquidity needs are generally managed by borrowing to cover any shortfall and lending to earn a modest interest on any excess.

The rate of interest earned on the banks' money is based on the current federal funds rate. This rate, also known as the interbank rate or the overnight rate, is actually set by the banks themselves. It is not "set" by the Fed per se, but is affected by the the one rate the Federal Reserve actually does set, which is the discount rate. The Fed has a target range it tries to keep the Fed Funds within, but they don't actually set it...That is up to the banks involved in that transaction.

The federal funds rate is a tool that the Federal Reserve uses to increase or decrease the amount of cash in the system overall. A low rate encourages banks to borrow freely while a higher rate discourages such activity.

In the economic crisis of 2008 that kicked off the great recession, the board cut the target range of the rate to between 0% and 0.25% and kept it there for seven years to encourage investment and borrowing. A series of modest increases pushed the target up to a range of 2.25% to 2.5% in December 2018. Then, in response to the economic fallout of the 2020 crisis, the Fed again cut rates to close to 0%.

This does not mean that a consumer will be able to directly take advantage of near-zero rates. The interbank rate is available only to the largest and most creditworthy financial institutions. However, all interest rates for borrowing or saving money are based on that key federal fund's rate, so a rate for a mortgage or a credit card will be based on the federal funds rate plus a premium.

The Interbank Rate in Foreign Exchange

The alternate definition of interbank rate is relevant to the interbank market, the global market used by financial institutions to buy and sell foreign currencies. In this case, the interbank rate or interbank exchange rate is the current value of any currency as compared to any other currency. The rates fluctuate constantly by fractions when the market is open.

Most of this trading is done by the banks to manage their own exchange rate and interest rate risk, though they also trade on behalf of some large institutional clients.

The interbank rate is what you see when you compare any two currencies in an online currency calculator. As with the interbank interest rate, consumers are not going to get the interbank foreign exchange rate when they exchange money. They will get the interbank rate, plus a premium that represents the profit of the company that exchanges the money.