In the world of finance, interest is the cost of money. The amount of interest paid to borrow funds is a function of current market rates, the availability of funds, and other factors such as loan length or past credit history. Banks are also subject to paying interest when they borrow funds. The most competitive, or lowest rate of interest is the interbank rate, which is the rate banks charge each other on short-term loans.
In order to better understand how the interbank rate, also referred to as the overnight rate, is used, it is important to understand how the rate originated. Banks create income by lending out money and charging a stated rate of interest on those borrowed funds. Since banks lend out deposits to borrowers, they only have a percentage of the total deposit value on hand. In most large monetary systems, such as the system adopted by the United States and the Federal Reserve, it is necessary for banks to hold a certain amount of "cash on hand" in case customers need to withdraw funds. The system is meant to help prevent a “bank run,” or a withdrawal panic. If the reserve or minimum amount of cash on hand is too low, the bank must borrow funds. The rate at which banks borrow funds is referred to as the interbank rate.
One of the world’s most popular interbank rates is the London Interbank Offer Rate (LIBOR). It represents the best rate of interest a borrower can get on a loan and is used by the United States, Canada, Switzerland, and the U.K. as a reference rate. It is also used by market analysts and loan officers as a benchmark for pricing loans for less than perfect borrowers. For instance, a loan to a large corporation may have a stated rate of interest of LIBOR +.05, whereas a small start-up company may have a stated rate of interest equal to LIBOR +3.00. In general, the higher the risk of the borrower, the higher the rate of interest above LIBOR.
One factor which greatly influences the interbank rate is forex, or foreign exchange. Any nation which issues currency can participate in the currency trading market. Central banks use the interbank rate as a factor in setting monetary policy. In general, an increase in the interbank rate is a sign that there has been a decrease in the flow of capital. Likewise, decreasing interest rates are a sign that there has been an increase in the flow of capital. As the cost of money goes up, fewer people can afford to access capital and a credit crunch ensues. As the cost of money goes down, more people can afford to access funds and economies are booming. Changes in central bank monetary policy can greatly influence forex prices, which is why currency traders closely monitor decisions by large central banks.