Throughout a business day, a bank will transfer money to various parties such as foreign banks, large clients, other banks and its account. When closing the day, it may have an excess or shortage reserves in fractional reserve banking. If the bank realizes excess reserves or surplus funds, it may consider depositing or lending them to other banks that borrow from it. In such a situation, the depository institution will loan the funds to the other using an interest rate called overnight rate. This rate is the lowest interest available. As a result, only the most creditworthy institutions can access it and usually on a short-term basis. This article explains the benefit from current overnight comparison to depository institutions.
The amount of money a bank has after each working day will fluctuate, depending on customers’ deposit and withdrawal activities as well as its lending activities. Therefore, the bank needs to make daily fund comparison to decide if it will lend or borrow money from other banks that experience a shortage or surplus so that it can maintain the liquidity and stability of its banking system.
Furthermore, the overnight rates offer an efficient method for the bank to get short-term funding from central bank depositories. The central bank of a country will influence the overnight rate and therefore banks can use it as a good predictor for the changes of short-term interest rate for clients in the broader economy. A higher overnight rate will mean more expenses for borrowing money. Besides, the rates tend to decrease when liquidity increases and rise when liquidity falls. As a result, a country can use it as an indicator of its overall banking system and economy health.
Benefits of overnight rate
This lower interest rate tends to stimulate an institution’s economic activity. The reduced interest encourages businesses to spend on capital, which boosts the long-term performance of their economy.
A second benefit is improving banks’ capacity to lend and their balance sheets. Many banks’ capital tends to decrease during the financial crisis, limiting their ability to give loans during the early stages of recovery.
The third advantage of overnight rate is that it can raise asset prices. When the overnight rate of a country increases, the public will have more cash balances than it wants to hold. Following this, individuals will end up using the excess fund to purchase assets such as corporate or house equities and other goods and services. In response, the demand for these goods will rise, increasing their price.