What it means
Banks do not hold their money in neat balance. On any given day one bank may have received more deposits than it can lend out, while another is short of cash to meet payments and regulatory requirements.
Interbank deposits let the first bank place its surplus with the second, so that both are better off. The deposits come in different lengths.
Overnight deposits are repaid the next business day, while term deposits run for a week, a month, three months or longer. The rate depends on the length, the standing of the borrowing bank and the general level of interest rates set by the central bank.
These rates are important well beyond the banking sector. Benchmark rates used to price business loans, mortgages and derivatives are built from what banks charge each other, or from market transactions that reflect it.
When interbank rates rise, the cost of borrowing for companies and households usually follows. Interest is normally simple rather than compound for these short periods.
It is calculated using a day-count convention, which is a standard way of counting the days in a period and the days in a year. For the US dollar and many other currencies the year is taken as 360 days.
Interbank deposits carry credit risk, which is the risk that the borrowing bank cannot repay. In normal times this risk is small, but in a crisis banks may stop trusting one another, rates jump and some banks cannot borrow at all.
Central banks often step in to provide liquidity at those moments. For non-bank readers, the practical lesson is that the interbank market is the plumbing that keeps the payments system working.
A company's payroll, supplier payments and loan drawdowns all rely on banks being able to fund themselves smoothly behind the scenes.
In practice
Real-world examples.
Example
A regional bank has collected $15,000,000 more in customer deposits than it can safely lend. Its treasury desk places the money with a larger bank for one week to earn interest rather than leave it idle. The desk records the placement as an asset on its balance sheet, and the interest earned is income that accrues day by day until the deposit matures.
Example
A large bank expects heavy payments to leave its reserve account short at the end of the month. It borrows $40,000,000 from other banks for three days and repays it when customer funds arrive.
Example
A corporate treasurer notices that the three-month interbank rate has risen by half a percentage point. She asks her bank how the increase will affect the company's floating-rate loan and updates her cash forecast.
Formula
Calculation
Interest = Principal x Annual rate x Days / 360
A bank places $20,000,000 with another bank for 30 days at an annual rate of 3.6%. The calculation is 20,000,000 x 0.036 = 720,000 for a full year, and for 30 days the interest is 720,000 x 30 / 360 = $60,000.
At maturity the borrowing bank repays 20,000,000 + 60,000 = $20,060,000 to the lender.Case study
Seen in the real world.
Halcyon Trust Bank is an illustrative, fictional mid-sized bank that funds most of its lending from customer deposits. At the start of one quarter it held $120 million more in deposits than it had loan demand for.
The treasurer split the surplus. She placed $70 million for 30 days at 3.6% and $50 million overnight at 3.4%, expecting to earn 70,000,000 x 0.036 x 30 / 360 = $210,000 on the term placement.
She also set a limit on how much could be placed with any single bank. In this illustrative story, one counterparty was later downgraded and the limit meant Halcyon had only a small exposure, which protected the bank from a loss. The deposit was repaid in full on the due date, and the interest income was recorded in the accounts evenly across the month rather than all at maturity. The treasurer also reported the placement to the risk committee, because each interbank exposure counts towards the bank's overall limits. The treasurer also compares the rate achieved with published benchmarks, so the board can see whether the desk is earning a fair return for the risk it accepts.
Watch out
Common mistakes.
- Treating interbank deposits as risk free, when the borrowing bank could fail to repay and exposure limits are needed.
- Calculating interest on 365 days when the market convention for the currency uses 360.
- Confusing interbank deposits with customer deposits, which are placed by the public and companies and not by banks.
Questions
People also ask.
Who takes part in the interbank deposit market?
Banks and certain large financial institutions, and not individuals or ordinary companies.
Why do banks lend to each other?
To use surplus cash profitably and to cover shortfalls quickly, so that every bank can meet its payments and reserve needs.
What happens when the interbank market freezes?
Banks stop lending to one another, short-term rates spike and central banks may supply emergency liquidity.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%