Interbank Lending Squares the Reserves Payments Move Around
Payments between customers of different banks leave one short of reserves and another long. The market that squares those positions is small, essential, and prone to freezing.
Why the Market Exists
When a customer of one bank pays a customer of another, reserves move between the two banks. Across a day, millions of such payments leave some banks with surplus reserves and others short.
Banks that are short must obtain reserves. Banks with surplus would rather earn something on them than hold them idle.
The interbank market is where those positions are matched, mostly overnight, mostly unsecured, at rates that sit close to the central bank policy rate.
The market exists to square positions created by ordinary payments, not to fund lending. It is plumbing, and it is only visible when it stops working.
The Reference Rate Function
Because interbank rates reflect the cost of short term bank funding, they became the reference for an enormous volume of financial contracts: floating rate loans, derivatives, mortgages, and corporate borrowing.
LIBOR, the London Interbank Offered Rate, was the dominant benchmark. It was compiled from submissions by panel banks estimating what they would pay to borrow.
Two problems emerged. The submissions were estimates rather than transactions, particularly as unsecured interbank lending declined, so the rate described a market that was barely happening. And the estimates were manipulable, which several institutions were found to have done.
The replacement benchmarks are based on actual transactions in the overnight secured market, which is far more active. The transition required repapering an enormous volume of contracts.
The 2007 Signal
The first clear indication of the coming crisis appeared in this market.
The spread between the interbank rate and the expected policy rate, watched as a measure of bank funding stress, widened sharply in August 2007.
| Spread condition | What it indicates |
|---|---|
| Narrow | Banks lend to each other freely |
| Widening | Counterparty concern rising |
| Very wide | Banks will not lend to each other at all |
Banks stopped lending to each other because none could assess which counterparties held damaged assets. Uncertainty about who was exposed made everyone unwilling to lend to anyone, which is a different problem from knowing a specific bank is weak.
Why It Freezes So Completely
Unsecured overnight lending has almost no protection. There is no collateral, and the return is a fraction of a percent for one night.
The asymmetry is severe: a small return against the possibility of losing the entire principal. Any meaningful doubt about a counterparty makes declining to lend obviously correct.
That is why the market goes from functioning normally to not functioning at all with very little in between. There is no rate high enough to compensate for genuine uncertainty about repayment overnight.
What Replaced It
Unsecured interbank lending declined substantially after the crisis and never recovered its former volume.
Two things replaced it. Secured lending through repurchase agreements, where collateral removes most of the counterparty concern. And large reserve balances created by quantitative easing, which meant banks simply held enough reserves not to need to borrow.
A system with abundant reserves has less need for an interbank market, which is why the benchmark reform mattered so much: the market the old benchmark measured had largely stopped existing.
The Bottom Line
The interbank market squares reserve positions created by ordinary payments, and its rates became the reference for a vast volume of contracts. It freezes completely rather than gradually, because unsecured overnight lending offers too little return to justify any doubt. Its decline after 2008, replaced by secured lending and abundant reserves, is what forced the move to transaction based benchmarks.