The overnight rate is generally the

interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, t ...

that large

bank A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital m ...

s use to borrow and lend from one another in the overnight market. In some countries (the

United States The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country Continental United States, primarily located in North America. It consists of 50 U.S. state, states, a Washington, D.C., ...

, for example), the overnight rate may be the rate targeted by the

central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a centra ...

to influence

monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for federal funds, very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money s ...

. In most countries, the central bank is also a participant on the overnight lending market, and will lend or borrow money to some group of banks. There may be a published overnight rate that represents an average of the rates at which banks lend to each other; certain types of overnight operations may be limited to qualified banks. The precise name of the overnight rate will vary from country to country.

Background

Throughout the course of a day, banks will transfer money to each other, to foreign banks, to large clients, and other counterparties on behalf of clients or on their own account. At the end of each working day, a bank may have a surplus or shortage of funds (or a shortage or

excess reserves Excess reserves are bank reserves held by a bank in excess of a reserve requirement for it set by a central bank. In the United States, bank reserves for a commercial bank are represented by its cash holdings and any credit balance in an account ...

fractional reserve banking Fractional-reserve banking is the system of banking operating in almost all countries worldwide, under which banks that take deposits from the public are required to hold a proportion of their deposit liabilities in liquid assets as a reserv ...

). Banks that have surplus funds or excess reserves may lend them (often at a multiple of their legal

reserve ratio Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the commercial bank's reserve, is generally determined by the centra ...

, if any) or deposit them with other banks, who borrow from them. The overnight rate is the amount paid to the bank lending the funds. Banks will also choose to borrow or lend for longer periods of time, depending on their projected needs and opportunities to use money elsewhere. Most

central banks A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...

will announce the overnight rate once a month. In Canada, for example, the

Bank of Canada The Bank of Canada (BoC; french: Banque du Canada) is a Crown corporation and Canada's central bank. Chartered in 1934 under the ''Bank of Canada Act'', it is responsible for formulating Canada's monetary policy,OECD. OECD Economic Surveys: C ...

sets a target bandwidth for the overnight rate each month of +/- 0.25% around its target overnight rate: the Bank of Canada does not interfere in the overnight market so long as the overnight rate stays within its target band, but the Bank will use its reserves to lend or borrow in the overnight market to ensure that the overnight rate stays within its announced bandwidth.

Measure of liquidity

Overnight rates are a measure of the liquidity prevailing in the economy. In tight liquidity conditions, overnight rates shoot up. Overnight rates may also shoot up due to lack of confidence amongst banks, as was observed in the liquidity crunch of 2008. In order to measure liquidity situation, the spread between risk-free rates and overnight rates is considered. The

TED spread The TED spread is the difference between the interest rates on interbank loans and on short-term U.S. government debt ("T-bills"). TED is an acronym formed from ''T-Bill'' and ''ED'', the ticker symbol for the Eurodollar futures contract. In ...

is a liquidity indicator for the U.S., which is the difference between LIBOR and Treasury bills.

References

{{finance-stub Banking Interest rates

Background

Measure of liquidity

See also

References