What it means
Banks constantly end each day with either surplus cash or a shortfall, and the interbank market lets them square up. The rate paid on those overnight and short-term loans is the interbank rate, and it moves with the central bank's policy rate plus whatever premium banks demand for lending to each other.
Its importance to non-banks comes from pricing. Business loans, overdrafts, leases and interest rate swaps are commonly quoted as a reference rate plus a margin, so the interbank rate is the base and the margin is the price of the borrower's own credit risk.
The same term is used loosely in currency markets, where the interbank rate means the wholesale exchange rate at which banks trade with each other. This is the rate quoted on financial news screens, and it is always better than the rate a business or traveller is offered at the counter.
Reference rates have changed considerably in recent years. Older rates based on submitted estimates of borrowing costs have largely been replaced by rates calculated from actual overnight transactions, which are harder to influence and are considered close to risk free.
The nuance to remember is that the interbank rate is a wholesale rate you can observe but not obtain. A business quoted the reference rate plus 2.2% is paying the interbank rate indirectly, and only the margin is genuinely negotiable.
In practice
Real-world examples.
Example
A property developer signs a five-year facility priced at the reference rate plus 3%. When the central bank raises rates twice in a year, the developer's interest bill climbs even though the negotiated margin never changed.
Example
A finance director comparing three lenders ignores the headline rates and compares only the quoted margins, because all three price off the same interbank benchmark and the margin is the only part that reflects the lender's view of the company.
Example
An importer checks the interbank exchange rate before agreeing a currency deal and finds its bank is quoting 1.4% away from it. Armed with that number, the importer negotiates the spread down to 0.6% on a $2,000,000 payment, saving $16,000.
Formula
Calculation
Interest on a short-term interbank loan is calculated as: Interest = Principal x Rate x (Days / 360), using the money market day count convention.
One bank lends another $50,000,000 for 30 days at an interbank rate of 4.80%.
Annual interest at that rate = $50,000,000 x 0.048 = $2,400,000.
For 30 days out of 360: $2,400,000 x (30 / 360) = $200,000.
The borrowing bank repays $50,200,000 at the end of the month.
Now apply the same reference rate to a business loan. A manufacturer borrows on a facility priced at the interbank rate plus a 2.20% margin, so its rate is 4.80% + 2.20% = 7.00%. On a $3,000,000 drawn balance, annual interest is $3,000,000 x 0.07 = $210,000. If the interbank rate rises to 5.80% and the margin is unchanged, the rate becomes 7.80% and annual interest rises to $234,000, an increase of $24,000 that the borrower cannot negotiate away.Case study
Seen in the real world.
Marchwood Components is an invented manufacturer used for this illustrative case. It held a $6,000,000 revolving facility priced at the interbank rate plus 2.5%, and its budget assumed a flat interest cost because the margin had been fixed for three years.
Over eighteen months the interbank benchmark moved from 1.5% to 5.0%. Marchwood's all-in rate rose from 4.0% to 7.5%, and on an average drawn balance of $4,000,000 its annual interest cost rose from $160,000 to $300,000. Nothing about the company's credit quality had changed, and no one had renegotiated anything.
The treasurer's mistake was budgeting the all-in rate as a constant rather than modelling the reference rate separately from the margin. Marchwood subsequently fixed the reference rate on half the facility through a swap, which capped the exposure while keeping flexibility on the rest. This illustrative example shows why the two components of a loan rate deserve separate attention.
Watch out
Common mistakes.
- Believing a business can borrow at the interbank rate, when it is a wholesale rate between banks and every commercial borrower pays a margin above it.
- Budgeting a floating loan at today's all-in rate for several years, which ignores the fact that the reference component moves with central bank policy.
- Confusing the interbank exchange rate seen on news screens with the rate a bank will actually deal at, which always includes a spread.
Questions
People also ask.
Why is the interbank rate lower than a business loan rate?
Because lending to a large regulated bank for a few days carries far less credit risk than lending to a company for several years.
Who sets the interbank rate?
No single body sets it, it emerges from actual transactions between banks, though it tracks the central bank's policy rate closely.
Does the interbank rate affect a fixed-rate loan?
Not during the fixed period, but it heavily influences the rate available when the loan is refinanced or the fixed term ends.
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