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Where the Money Is
An Overview of Interbank Lending, The Fiscal Action Behind LIBOR
February 8, 2009
According to legend, when asked why he robbed banks, holdup man Willie Sutton replied, “Because that’s where the money is.” We assume that banks always have the money, and the rest of us go there to get loans. Sometimes, however, banks need loans too. Employing a sense of logic that Mr. Sutton would appreciate, when banks must borrow, they go to other banks. This is known as interbank lending, a daily occurrence between the world’s depository institutions. Although it constitutes business between banks, this type of transaction has tremendous significance for the rest of us. Interbank lending is the genesis of the LIBOR index, the premier global indicator of borrowing costs and market health.
Banks are required to hold reserves, a monetary amount equal to a pre-set percentage of all outstanding loans and obligations. Reserves must be liquid such as cash, financial instruments that can be quickly used to cover withdrawals and other demands on the bank. Liquidity ideally comes from investment income, loan repayments, and new deposits. When banks’ reserves drop below legal limits, they must borrow to make up the deficit. The loans banks obtain from other banks are typically unsecured (no collateral involved) and short term, ranging from overnight to one year. In kind, LIBOR has separate indices for each such maturity: overnight LIBOR, 1-month LIBOR, 3-month LIBOR, 1-year LIBOR.
The interbank lending market is the forum in which banks extend and receive credit amongst themselves. Banks with excess reserves are in position to be lenders, granting credit to institutions needing additional funds to maintain their reserve levels, be it for a term measured in hours, days or months.
Central banks affect the availability of funds by dictating target rates for overnight interbank loans. The federal funds rate in the United States is one such guiding figure, set by the Federal Reserve. Ultimately, banks decide the cost and accessibility of funds for other banks. As they do with all loans, banks determine the risks involved with interbank lending. When they decide the risk is higher, they charge more interest.
LIBOR is a filtered average of rates for interbank loans available between member institutions of the British Bankers’ Association (BBA). There are separate LIBOR indices for loans of different durations (as previously mentioned) and different major currencies. When banks are mutually confident, interbank lending rates drop as reflected in a declining LIBOR. When banks worry that their peers have a greater chance of defaulting, they raise rates to offset the risk.
So, the next time you see an ad with the message “banks are people too,” don’t sneer. Banks borrow money, just like us, and they pay more for the privilege when lenders are less sure of their ability to repay, again just like we do. So we watch LIBOR to see how banks are feeling about each other every business day, which is important, because as Willie Sutton always knew: that’s where the money is.