Interbank Lending

What Is Interbank Lending?

Interbank lending is the practice of banks borrowing from and lending to each other, primarily on an overnight basis, to manage their reserve positions and meet liquidity needs. In the U.S., this activity occurs in the federal funds market, where the rate on overnight unsecured loans between banks is the federal funds rate, the primary monetary policy benchmark.

The interbank market serves as the plumbing of the banking system, ensuring that reserves flow from where they are plentiful to where they are needed. Historically, it was the primary mechanism for distributing liquidity across the banking system.

Why It Matters for Markets

The interbank lending rate is the starting point for virtually all other interest rates in the economy. The Federal Reserve targets the federal funds rate as its primary policy tool, and changes in this rate cascade through the financial system to affect mortgage rates, corporate borrowing costs, and consumer loan rates.

The health of the interbank market is a critical barometer of financial system stability. When banks freely lend to each other at or near the target rate, the financial system is functioning normally. When interbank lending freezes or rates spike dramatically above the target (as in September-October 2008), it signals a fundamental breakdown in trust between financial institutions.

During the 2008 crisis, the interbank market effectively seized as banks hoarded reserves and refused to lend to each other due to counterparty credit fears. This freeze forced the Fed to intervene with massive liquidity injections and emergency lending facilities. The episode demonstrated that the interbank market is not just a technical banking function but a cornerstone of financial stability.

The Shift to Ample Reserves

The interbank lending market has been fundamentally transformed since 2008. Before the crisis, the Fed operated under a "scarce reserves" framework, using open market operations to adjust the precise level of reserves and steer the funds rate. After multiple rounds of quantitative easing flooded the system with trillions in excess reserves, there was no longer a need for most banks to borrow reserves overnight.

The Fed adapted by shifting to an "ample reserves" framework, using administered rates (IORB and the ON RRP rate) to control short-term rates. Traditional interbank lending volumes have declined dramatically, with most overnight funding activity migrating to the repo market. This structural shift means that the federal funds rate, while still the policy target, is determined by a much smaller volume of transactions than before.