Interbank Lending Rate

The interbank lending rate is the interest rate at which banks lend reserve balances to each other overnight. In the United States, this is the federal funds rate, the rate at which banks lend balances held at the Federal Reserve to meet reserve requirements or maintain desired reserve levels. It is the most frequently traded and economically sensitive interest rate in the world. Central banks target the interbank lending rate as their primary monetary policy tool, and movements in it cascade through all other interest rates—mortgages, corporate bonds, credit cards, savings accounts.

Why banks borrow and lend overnight

Banks are required by Federal Reserve regulation to hold reserve balances proportional to their deposit base (or under current regimes, to hold some minimum level). Reserves are deposited at the Fed and don’t earn interest (until recently, when the Fed began paying interest on reserves). Each night, a bank’s reserve balance fluctuates based on customer deposits and withdrawals, check clearing, and settlement of securities trades. A bank that finds itself below its required level at the end of business borrows from another bank that has excess reserves.

The transaction is simple: Bank A calls Bank B (or uses a broker) and says “I need $10 million overnight.” Bank B agrees to lend at a quoted rate, say 5.25%. Bank A receives a $10 million credit to its Fed account and must repay $10 million plus interest the next business day. These loans are unsecured—backed only by the banks’ credit, not collateral.

The interest rate on these loans is the interbank lending rate. It fluctuates minute-by-minute as supply and demand for overnight reserves change. If many banks are short of reserves (perhaps deposit outflows spiked), the lending rate rises. If reserves are abundant, it falls.

Central bank control through open market operations

Central banks don’t directly set the interbank lending rate; they target it by controlling reserve supply. The Fed uses open market operations (OMOs) to add or drain reserves. If the Fed wants the rate at 5%, it adds reserves until the supply-demand balance for overnight funds implies 5% as the equilibrium rate. If the rate drifts to 5.2%, the Fed adds more reserves until it stabilizes at 5%.

The Fed also sets the interest on reserves, the rate paid on balances banks hold at the Fed. This creates a ceiling—no bank will lend to another bank at a rate below what the Fed pays. And it sets the discount rate, the rate charged to banks that borrow directly from the Fed’s discount window, creating a floor. The interbank rate trades in a band between these two.

The federal funds rate is not a single rate but a range. The Fed sets a target range, e.g., 4.75%–5.00%, and uses tools to keep actual transactions within that band. The effective federal funds rate is a volume-weighted average of all overnight repo and unsecured lending transactions between banks.

Transmission to the broader economy

The interbank rate is the foundation of the interest rate transmission mechanism. When the Fed raises the interbank rate target, banks’ cost of funds rises. Banks respond by raising rates they charge customers—mortgages, credit cards, business loans. A 0.5 percentage point increase in the fed funds rate translates to roughly a 0.3–0.5 point increase in mortgage rates and a larger increase in credit card rates (which adjust faster). Over quarters, higher rates reduce borrowing, investment, and consumption, cooling inflation.

Conversely, if the Fed cuts the interbank rate, banks lower customer rates, encouraging borrowing. This is the monetary transmission mechanism: Fed policy → interbank rate → bank lending rates → borrowing and spending → inflation and employment.

The relationship isn’t mechanical. In recessions when credit risk is high, banks may raise lending rates even as the interbank rate falls because their default risk perception has spiked. This happened in 2008: the Fed cut the fed funds rate to near zero, but lending rates to businesses and consumers barely budged because banks were hoarding capital. The transmission broke.

Stress and the 2008 crisis

During the 2008 financial crisis, the interbank lending market froze. Banks stopped trusting each other’s creditworthiness. Overnight lending rates spiked, then borrowing activity collapsed. Banks unwilling to lend meant other banks couldn’t fund operations. The Fed intervened massively, providing term funding facilities and emergency lending to unstick the market.

The crisis revealed a fragility: the interbank market works smoothly only when banks trust each other. In stress, it seizes. The Fed’s response included not just emergency lending but also explicit commitments to keep rates low and financial conditions stable—reducing fear and restoring confidence.

This is why modern monetary policy has expanded beyond just targeting the interbank rate. The Fed now uses balance-sheet tools (quantitative easing, asset purchases) to directly influence longer-term rates and liquidity, reducing reliance on the interbank market channel.

Recent changes: LIBOR reform and SOFR

The traditional benchmark for interbank lending in dollars was LIBOR (London Interbank Offered Rate), an estimated rate compiled from banks’ self-reported lending quotes. LIBOR was used in trillions of dollars of contracts and derivatives. But in 2012, investigations revealed LIBOR manipulation—banks were misreporting rates to profit on derivatives positions or to appear healthier. Trust collapsed.

Regulators pushed for a shift to SOFR (Secured Overnight Financing Rate), which is based on actual transactions (repo market trades) rather than estimates. SOFR is harder to manipulate because it’s based on observed prices. The transition from LIBOR to SOFR for new contracts is nearly complete. Legacy LIBOR contracts will be converted or allowed to wind down by 2024–2025.

Impact on savers and borrowers

For savers, interbank rates matter because banks pass rate changes to savings accounts slowly. When the Fed raises rates, savings accounts lag by quarters. Banks profit from the spread. For borrowers, higher interbank rates mean higher mortgage, credit card, and auto loan rates. The interbank rate is the upstream price that determines downstream consumer rates.

The term premium on longer-term rates is separate from the interbank rate but influenced by Fed policy signals about future rate paths.