The Interbank Market: Where Banks Lend to Each Other

The interbank market is where banks lend to each other, almost always for one night. A bank that ends its day short of balances borrows from a bank that ends its day long. No venue matches these trades and no institution stands in the middle. Each side picks whom it is willing to face, and until the morning the lender holds a promise and nothing else.

The need for this market is not a choice anybody made. A bank's day does not end square. Money arrives and money leaves all day long on instructions the bank did not write and could not time: salaries land in thousands of accounts on the same morning, a tax payment goes out, a company draws down a loan it arranged weeks ago, a large customer moves a balance to a bank across the road. None of that is planned by the bank. All of it moves the bank's balances.

So the close of business finds the bank holding either more balances than it needs or fewer, and that difference has to be dealt with before the books shut for the day. The cheapest way to deal with it is to find another bank sitting on the opposite side of the same problem. The opposite-side match is the whole of it, and everything that follows comes out of it: two banks with opposite problems have to find each other and agree terms with nobody standing between them.

What is a Financial Market, and what has to be true before a claim can change hands?

A financial market is any arrangement in which a financial claim changes hands. The definition is worth one sentence and no more. Four conditions have to hold before that change of hands can actually happen, and they are not equally hard.

Somebody has to be willing to give the claim up. Somebody has to be willing to take it. The two of them have to accept the same price. And each of them has to be sure the other will do what it said. The first three arrange themselves on any ordinary evening, and the fourth is the difficulty that every institution of market plumbing was built to solve.

Here is the everyday version, and it is closer than it looks. Two neighbours can agree a price for a second-hand scooter in about a minute. Neither of them needs an institution to find the other, neither needs help wanting the deal, and the number gets settled over a cup of tea. The whole difficulty arrives in the next thirty seconds, when one of them has handed over the money and the other has not yet handed over the scooter, or the other way round. Everything difficult about a financial market lives in that thirty seconds, and it lives there whether the claim is a scooter or a few hundred crore of balances between two banks.

Why does a bank end each day needing to borrow or lend at all?

Because both ends of a bank move on somebody else's instructions. Deposits arrive and leave when customers decide. Lending goes out and comes back when borrowers decide. Neither end is under the bank's control on any given Tuesday, and the two ends are not obliged to move by the same amount on the same day. The gap at the close is a fact of the banking day rather than a mistake anybody made, and a market exists to close it every single evening.

Worked on a bank, the shape of the thing becomes visible. Suvarna Commercial Bank Limited, an invented bank used for its shape rather than its size, reports total assets of Rs 2,40,000 crore and deposits of Rs 1,92,000 crore. The division rather than the share taken on trust: Rs 1,92,000 crore over Rs 2,40,000 crore is 80.0 per cent of total assets. Four rupees in every five that the bank is working with came in as somebody's deposit, and every one of those rupees can be asked for.

Now the other end. Suvarna Commercial Bank Limited reports advancesThe money a bank has lent out and is waiting to be repaid. How a bank decides what to lend and to whom is covered separately. of Rs 1,44,000 crore. The division again, with its base named alongside: Rs 1,44,000 crore over deposits of Rs 1,92,000 crore is 75.0 per cent of deposits. Three quarters of what came in the front door has gone out the back as lending, and the remaining Rs 48,000 crore of deposits is doing other work inside the bank.

The last row of that table is deliberate rather than a hole in the working. There is no figure anywhere for what Suvarna Commercial Bank Limited owes other banks tonight, or for what they owe it. The shape remains visible without that figure, and the shape is enough: two very large ends, both moving on instructions the bank did not time, cannot land square at the close. A reader who wants the actual position of an actual bank now knows precisely which line to go and look for.

Every figure above came out of a division printed beside it: Rs 1,92,000 crore over Rs 2,40,000 crore, Rs 1,44,000 crore over Rs 1,92,000 crore, and the same Rs 1,44,000 crore over Rs 2,40,000 crore to show what changing the base does. All three take a pen and a minute.

Who is on each side of the market where banks lend to each other?

Two perfectly ordinary banks, and it is worth saying plainly that neither of them is in trouble and neither of them is clever. On one side is a bank ending the day long of balances. Balances sitting where they are earn it very little. On the other is a bank ending the day short, and its gap has to be closed before the books shut. The two banks are the two ends of the same day, and on any given evening either could be at either end.

The lending bank is buying a small return on money that would otherwise sit idle, and the borrowing bank is buying a night. The whole trade fits in that one sentence, and it is also why the borrowing is overnightOut tonight and back the next morning. Most borrowing between banks runs for exactly this long, which is the shortest useful period there is. rather than anything longer: neither bank wants a long commitment to a problem that will look different by tomorrow afternoon, and the shortest possible arrangement is the one both sides can live with.

The household version is a street of shopkeepers who all bank their takings at the end of the day. One of them has had a busy Saturday and is holding more cash than the shutters should hold overnight. Another has paid a supplier that morning and is short for the deposit slip. The two shopkeepers know each other, one lends the other the difference, and the money comes back on Monday. Nobody in that street thinks of it as a market. The street is a market, and it has all four conditions in it.

Who holds what at the moment the money moves between two banks?

The question of who holds what runs through the whole subject, and the answer is least comfortable in this setting. Follow the money. At the close it leaves the lending bank's balances and arrives in the borrowing bank's. Nothing comes back the other way. From that instant until the money returns the next morning, the lending bank holds no money and no security: what it holds is a promise to be paid back.

Everything built afterwards is built to remove exactly that position, so the position is worth sitting with rather than moving past. The lender is not partly exposed and it is not exposed to a fraction. For the whole of that night the entire sum is out of the door with nothing standing behind it except the other bank's word and the lender's own reading of whether that word is good. There is no institution in this arrangement at all, so there is nobody to appeal to at three in the morning.

Notice what the lending bank actually did before it agreed. The lending bank did not check a rulebook and it did not consult a third party. The lending bank formed a view about the other bank, decided the view was good enough, and sent the money. Forming a view is the machinery of this market, and it is the entire machinery.

What is an OTC Market, and how does it differ from a market with a central book?

The label explains nothing, so the arrangement is better worked as an absence. In an over the counter market there is no central book that every order arrives at, and no single place where a price is made for everybody. Two parties find each other, agree between themselves, at a number they settle between themselves, and each of them decides separately whether it is willing to deal with the other at all. Nothing gathers them. Nothing pairs them off.

Because each side chooses whom it faces, a view of the other party is not something formed beside the price, it is part of the price. The consequence matters more than it looks, and it is the one most often missed. On a central book a price is taken without anybody knowing whose order was behind it. The arrangement has been built so that knowing does not matter. Here it matters enormously. A bank the other side is unsure about does not get a worse number. Instead of a worse number, the bank gets no number at all, and the other side declines to be its counterpartyThe party on the other side of an agreement, and the one whose failure to perform would be costly. Choosing whom to accept as one is the whole of the decision described here. and goes to find somebody else.

The asymmetry between a worse price and no price returns in a much less comfortable form. A market where the answer to a doubt is a worse price behaves quite differently from a market where the answer to a doubt is silence, and this one is the second kind.

What changes when the borrowing is secured rather than unsecured?

The words themselves do no work. The two arrangements separate by what actually changes hands. In an unsecured overnight loan exactly one thing moves: money, out tonight and back in the morning. In a secured one, securities move to the lender's side as well, and they sit there for as long as the money is out. If the morning goes badly, the lender in the second arrangement is holding something it can sell, and the lender in the first is holding a claim it will have to go and pursue.

The reading rule is a single question: what is the lender holding while the money is out, and the answer separates the two arrangements completely. Everything else about them is identical. The sum is the same size, the night is the same length, the promise to repay is worded the same way. One item sits on the lender's side in one case and does not in the other, and that single item is the whole of the difference.

Why is money lent between banks for one night the first price in the system?

Because it is the shortest borrowing there is and, by construction, among the least exposed, so it sits at the centre of everything else. A borrowing that lasts one night carries less of almost every worry that a longer borrowing carries, simply because there is less time for anything to happen. Every other borrowing in the economy is longer, or less certain, or both, and each of them is built outward from that centre rather than arrived at independently.

The direction of travel runs from the middle outwards: the policy rateThe rate the central bank sets to steer borrowing costs across the economy. How it is arrived at and how it travels outward is covered separately. acts on this market first, and reaches everything else afterwards. Sitting at the centre is why people who watch the system watch this market before anything else, and why a disturbance here is read as news about the whole system rather than as news about two banks.

A rate is a price. Prices move, and a price written down is wrong on the day it moves rather than merely old.

What is a Market Panic, and why does this market have so little to stop one?

A panic is not a fall in a price, and reading it as one is the commonest mistake made about it. A panic is the moment when enough participants stop being sure that the other side will do what it said, and stop trading altogether rather than trading at a worse number. Go back to the four conditions. Willing lenders are still there. Willing borrowers are still there. A perfectly good way of settling a number between two parties is still there. The fourth condition has gone, and it is the only one of the four that no participant can supply for itself.

No venue matches these trades and no institution stands in the middle to take the promise off either side, so the only thing holding this market open is each bank's judgement of the next one. Judgement does not go gradually and it does not go in one place. Everybody was relying on the same kind of reading, and everybody revises it on the same afternoon, so the judgement goes everywhere at once.

And here is the part that surprises people. The bank in question does not end up paying more. The bank ends up with nobody willing to lend to it at all. No number on offer fixes a lender that has decided not to face it, and a lender that will not face the bank is a harder problem than an expensive one.

The everyday version is exact rather than approximate. A shopkeeper who has let one regular customer settle up at the end of every week for years does not respond to a rumour by putting the prices up for that customer. The shopkeeper simply stops giving credit. Nothing was negotiated, no price changed, and an arrangement of many years is over by Tuesday afternoon.

What replaces judgement when a market will not rest on it?

Machinery, and it is worth drawing the opposite of everything described so far to see what that means. Where trades are matched by a venue rather than agreed one to one, where a single institution steps between the two sides and becomes the party each of them faces, and where the record of who holds what sits with a third institution that neither side controls, no participant has to form a view of whom it is dealing with. The view has been made unnecessary rather than made easier.

An institution that stands between the two sides and becomes the party each of them faces is called a central counterpartyAn institution that steps between the two sides of a trade and becomes the party each of them faces, so neither has to hold a view about the other. What one does, and how it gets there, is covered separately., and the institution that keeps the record of who holds what is a depositoryThe institution that holds securities in electronic form against a name, so that a change of holder is a change in a record rather than a movement of paper. Covered separately.. The work each of them does, in what order, and what has to be true before each step can happen, is covered separately and in detail.

The trade being made is between two ways of failing. Judgement is cheap to run and fails everywhere at the same moment. Machinery is expensive to build and fails one participant at a time. The contrast is the reason the institutions of market plumbing exist at all. Judgement is not bad. Judgement has no way of confining a failure, and machinery is built for almost nothing else.

How does somebody reading a bank's accounts actually use any of this?

Who sets the conditions banks work under in this market?

Several of the conditions named so far are not a bank's to set. Each is set by an authority and each is revised, so a figure printed for it would be incorrect rather than merely ageing. The rows below therefore carry an empty value column, with the authority printed inside the row where a value would otherwise sit. An empty column still teaches: it names which condition exists and where the answer to it lives.