Overnight Rate

The interest rate that depository institutions charge one another in the overnight market.

The overnight rate is the interest rate that depository institutions (mainly banks) charge one another in the overnight market. This is primarily done to maintain the reserve requirements of central banks.

Overnight rate

This rate is generally the lowest available interest rate to the most creditworthy institutions and is set by the central banks. They mainly set these interest rates to target monetary policies and economic growth.

Banks and financial institutions set these rates to handle any short-term needs when illiquid. A bank's liquidity fluctuates daily with the lending activities and the customers' withdrawals and deposits. 

This leads to a possible shortage or surplus of cash at the end of a business day. In this case, if a bank has a cash shortage, it borrows from other banks with plenty of money to maintain its reserve requirements.

For example, let's say Jim goes to bank A and needs to withdraw a big amount of cash in the coming days, but bank A doesn't have the necessary amount for Jim. Bank A would then borrow money from bank B at the specified rate set to meet the short-term needs of its customer Jim.

Understanding Overnight Rate

It is one of the country's most important components of economic activities. It serves as the basis of the prime rate, and this prime Rate is the basis of most other interest rates. The Prime Rate is the interest rate banks charge their most creditworthy customers.

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To further elaborate, it can be a good predictor of the movement of short-term interest rates since it is fundamentally influenced by the central banks

Hence, the higher the overnight rate, the higher the prime rate would tentatively be. The higher the prime rate, the more expensive it is to borrow money for an average person.

The concept was met to help banks access their short-term financings and meet any unexpected obligations and liquidity shortages, such as significant customer cash withdrawals.

The rate increases when liquidity decreases and loans are more challenging to get. The same goes for when the liquidity increases and loans are easier to get, the rate decreases. 

This means when the rate is high. The economy is slowing down. And when low generates economic growth. 

Effects of the Overnight Rate

The central bank can manipulate the rate to implement its monetary policies. If the economy slows down, the central bank can bring the rate down to stimulate growth and allow banks to borrow from each other at a lower rate.

Effects

This, in turn, lowers the interest rates banks charge on individuals. Which makes loans more affordable, and funds more obtainable to finance any expansion activities for businesses and individuals. 

Any changes to this rate has an indirect impact on mortgage rates. When the rate increases, it becomes costly for banks to settle their debts. 

To compensate, they will need to raise the longer-term rates through prime lending, and business and consumer rates.

As mentioned before, the overnight rate serves as the basis for the Prime Rate, which is the basis for most other interest rates. 

For example, the interest rate of variable mortgages is tied directly to the prime lending rate. If the exceptional rate increases, the rate of variable mortgages increases.  

Therefore, the overnight rate is a good measurement of the economy's health. Any changes in this rate can influence macroeconomic factors such as economic growth, inflation, and unemployment rate.

Key Takeaways
  • The overnight rate is the rate at which banks lend each other money.
  • The main goal is to maintain the reserve requirements of the central banks.
  • It is a good measure of the economy's health. 
  • The higher the overnight rate, the higher the prime rate. Making it more costly for consumers to borrow money.

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Researched and Authored by Jad Shamseddine | Linkedin

Reviewed and Edited by Abhijeet Avhale | LinkedIn

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