Interbank Market

What is the Interbank Market?

The interbank or interbank lending market represents a market specified for banks and financial firms where they can lend funds to each other within a period. This market is part of the interdealer market, specifically for banks and other financial institutions.

An interdealer market is a place for trading whose participants are banks and financial institutions. It is usually an Over-the-Counter Market (OTC) known as Pink Sheet Trading or Off-Exchange Trading that is decentralized and does not require any physical space. 

OTC is intended to trade securities and other financial instruments directly between two parties (buyer and seller). The transaction made by an intermediary is usually a broker/dealer representing a worldwide network of brokers/dealers and financial institutions. 

The intermediary usually is an Inter Dealer Broker (IDB) as a financial intermediary that facilitates the transaction process between its parties to trade different asset classes. 

The Interbank market reflects a network of financial institutions connected globally to facilitate trading directly with each other. The transactions are mostly short-term and mature between overnight, week, and up to six months and are even repayable within a week.

Banks are inclined to this market to reduce and manage the risk exposure arising from interest rates, market, and exchange rates. 

Generally, it has two types of markets, one for the interbank market to conduct transactions and lend money and the other for the interbank market for exchange transactions which will be discussed later in this article.

History of the Interbank Market

The main reason for interbank markets to be interconnected was the rise of globalization throughout the centuries. Increased trade of goods, capital, and labor across countries, inherently implied the eventual and undeniable dependence of the monetary system on one another.

The earliest informal Interbank Markets can be traced back to 17th-century England. Medieval money changers and particularly goldsmiths had to find ways to conduct transactions between themselves and their customers. This, however, had multiple costs attached to it. 

To mitigate these costs, 18th and 19th centuries banks became innovative and discovered more convenient ways to settle transactions by exchanging less sophisticated assets. This led to the creation of ‘clearing houses’, that accepted, cleared, and exchanged transactions on behalf of the banks. Eventually, this led to the establishment of formalized clearing arrangements. 

The 1944 Bretton Woods Agreement established a fixed exchange rate system, where currencies were pegged to the US dollar and the US dollar was pegged to gold. However, this system collapsed, leading to a shift towards floating exchange rates. Interbank markets adjusted to this change as currencies began to fluctuate more freely against each other. 

The late 20th century saw a boom in technological advancements that had a significant impact on interbank markets. Electronic networks and platforms intended for trading facilitated faster and more efficient transactions.

While the interbank was not decentralized and controlled; the Mexican crisis of 1994, the Asian Financial Crisis in 1997, the Dot-Com Bubble in the 2000s, and most importantly, the 2008 Global Financial Crisis, called for heavier regulation and changes in their practices.

As seen throughout history, interbanks evolved in response to changes in global economic conditions, technological advancements, and different regulatory frameworks, and will continue to do so.

Nature of Interbank Market

The Interbank Market consists of different components, including the spot market, forward market, and SWIFT. These involve different ways of settlement and transactions for trade agreements. 

1. A spot market, also known as the cash market, is a public financial place to trade different financial products and commodities for on-time delivery via exchange or Over The Counter-OTC. 

2. A forward market is an informal OTC market in which transactions are made based on contracts for future delivery intended for future exchange at an agreed date and price, also known as future contracts. 

3. SWIFT, or Society for Worldwide Interbank Financial Telecommunication, is a cooperative legal society founded in 1970 in Belgium. Its standardized system helps conduct secure transactions safely and reliably between banks. Some of its functions include: 

• Central banks refer to its services of interbank communications and financial transactions. 
• It aims to provide financial services involving the execution of the transactions and payments made between banks globally. Its primary function is to serve as the significant body messaging network through which international payments are initiated. 
• It helps transfer funds, or the wire transfer, a tool to transfer electronic funds from one bank to another made from one bank account to another. 

Loans within the interbank market involves an interbank rate or overnight rate when the loan is in its maturity. The interest rate is charged on short-term loans between banks. It is bank-to-bank transactions that are done in the money market. 

Financial institutions and banks lend funds to each other when they need liquidity to operate smoothly in their activities and meet their needs. For example, they give money when they are over their reserves and lend it to other banks. 

These banks trade mainly in lending, but other activities include currency trading, where a bank does the trading on behalf of a large customer. The nature of trading is usually proprietary, in which a transaction is done on behalf of a bank’s account. 

A market maker should be willing to pay prices to other participants and ask prices. Aside from banks involved in it like Citigroup and HSBC, trading firms play a crucial role, yet the extent to affecting the exchange rates varies, unlike big banks.

Interbank Market and the Financial Sector

As mentioned earlier, the interbank market gives liquidity to those banks that are in a severe shortage of money. These loans help banks sustain their functionality and operations while simultaneously stabilising the banking system and financial sector as a whole. 

Some of the roles include:

• It reduces the bank’s funding liquidity risk exposure. Funding liquidity risk exposure is the risk that occurs when a bank cannot pay its debts when they reach the due date for paying back customers.
• Banks in this market give their deposits to others and they are able to withdraw when they wish to. This enables the ‘lending’ banks to profit from these funds through different activities such as charging interest on their loans or investing in short-term securities.
• Primarily, the interbank market plays a crucial role in weakening the pressure from temporary liquidity shortages a bank faces. Therefore, it should simultaneously follow the reserve requirements set by its respective central bank. 

In the end, a bank that functions smoothly will not face any risk as it is getting loans from this market quickly at a cheaper cost. However, when a bank is dysfunctional, it will probably face risks that ultimately result in insolvency. 

Insolvency occurs when a bank that is the debtor cannot meet its obligations towards its creditors, who are its customers, by repaying them the money on time, resulting in bankruptcy. This case happens in two different ways: cash flow or balance sheet insolvency. 

Another key factor that needs to be considered is the interest rates benchmark for short-term loans. Potential concerns arise when fluctuations in interbank interest rates, acting as a benchmark within the unsecured market context, can impact both the financial sector and the country’s economy. 

These rates are a reference and benchmark when pricing various financial instruments, including Floating Rate Notes (FRNs), syndicated loans, and Adjustable Rate Mortgages (ARMs). In addition, they are used to analyze corporate cash flow as a form of discount rates. 
Thus, when stabilized and entrenched, these rates will simultaneously make the market functionality stable and efficient.

This is why the understanding of such benchmark rates and interest rates (determined by the country’s central bank) is vital.

Interbank FOREX Market

While the interbank rate is intended specifically for domestic banks to lend and borrow from each other; the FOREX market deals with currency trading and foreign exchange transactions. 

It is a place that facilitates banks to exchange currencies and thus represents the foreign exchange market. It is a decentralized market that operates primarily on working days. 

Although there is no specific designated physical location for such markets, many countries regulate these markets at their respective central banks where daily spot prices are published. 

This market developed after the collapse of the Bretton Woods Agreement and the Gold Standard, which were no longer helpful for countries and international trading. 

Generally, the interbank market is an integral part of the foreign exchange market. Hence, it channels most of the currency transactions representing a wholesale market where banks can do their transaction directly or via Electronic Brokering Platforms-EBS. 

EBS is a wholesale platform for banks to trade in the foreign exchange markets with market-making banks that connect many banks on its platform. It was created in 1990 through a partnership of large foreign exchange players. 

There was big competition as technology emerged, and companies wanted to take roles in this market. Reuters and Bloomberg facilitated the process for banks and did transactions with over billions of dollars, a high volume trading daily. 

Therefore, this is because of the floating rate system that many countries applied to their currencies and allowed for rapid and harsh trading worldwide, along with technology that costs less than any traditional way of trading. 

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Buller Loan
• Call Report
• Leverage
• Leveraged Buyout (LBO)
• Liquidity