8: Central Banks & Interbank Market

Federal funds

*overnight borrowings between US banks* to maintain their bank reserves at the Federal Reserve; (1) banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions; (2) transactions in the federal funds market enable depository institutions with reserve balances in excess of reserve requirements to lend reserves to institutions with reserve deficiencies; (3) these loans are usually made for one day only, that is, "overnight" - the interest rate at which these deals are done is called the federal funds rate

Eurodollars

US dollars deposited in foreign banks *outside the United States* or in *foreign branches of US banks*; (1) because these short-term deposits earn interest, they are similar to short-term Eurobonds; (2) American banks borrow Eurodollar deposits from other banks or from their own foreign branches, and Eurodollars are now an important source of funds for American banks

Quantitative easing

a central bank asset-purchasing program in which the bank *buys a specified amount of financial assets (securities) from commercial banks and other private institutions* - thus raising the prices of those financial assets, lowering their yield and simultaneously increasing the monetary base; (1) expansionary monetary policy to stimulate the economy typically involves the central bank buying short-term government bonds in order to lower short-term market interest rates: however, when short-term interest rates reach or approach zero, this method can no longer work; (2) in such circumstances monetary authorities may then use quantitative easing to further stimulate the economy by buying assets of longer maturity than short-term government bonds, thereby lowering longer-term interest rates further out on the yield curve associated problems: (1) quantitative easing can help ensure that inflation does not fall below a target, but risks include the policy being more effective than intended in acting against deflation (leading to higher inflation in the longer term, due to increased money supply), or not being effective enough if banks do not lend out the additional reserves;

Tapering

a gradual *winding down of central bank activities* such as asset-purchasing programs; (1) tapering activities is primarily aimed at interest rates and investor expectations of what those rates will be in the future; (2) these can include conventional central bank activities, such as adjusting the discount rate or reserve requirements, or more unconventional ones, such as quantitative easing (QE)

Interbank lending market

a market in which banks *extend overnight loans to each other* at the interbank rate; (1) banks are required to hold an adequate amount of liquid assets, such as cash, to manage any potential bank runs by clients; (2) if a bank cannot meet these liquidity requirements, it will need to borrow money in the interbank market to cover the shortfall (3) some banks, on the other hand, have excess liquid assets above and beyond the liquidity requirements: these banks will lend money in the interbank market, receiving interest on the assets,; (4) the interbank rate is the rate of interest charged on short-term loans between banks: banks borrow and lend money in the interbank lending market in order to manage liquidity and satisfy regulations such as reserve requirements -- the interest rate charged depends on the availability of money in the market, on prevailing rates and on the specific terms of the contract, such as term length

Eurobonds

bonds *denominated in a currency other than that of the country in which it is sold*; (1) a company selling a bond denominated in U.S. dollars sold in London (2) a bond denominated in euros is called a Eurobond only if it is sold outside the countries that have adopted the euro: bond denominated in Euros sold in the US

Foreign bonds

bonds sold in a *foreign country denominated in that country's currency*; (1) Porsche selling a bond in the US denominated in dollars; (2) a large percentage of US railroads built in the 19th century were financed by sales of foreign bonds in Britain

Eurocurrencies

foreign currencies deposited in banks *outside the home country*; (1) eurocurrencies are a variant of Eurobonds in that these short-term deposits earn interest similarly to short-term Eurobonds

Eurodollar market

the European market where US dollars can be *deposited and loaned for short periods of time*; (1) in this market, loans are made in the form of Eurodollars and products are denominated in the US currency; (2) however, because transactions are typically $1 million or more, only large institutional investors participate in this market - also, because this market is largely unregulated, banks can lend out 100 percent of the deposits they receive and therefore offer extremely attractive interest rates

LIBID rate

the average interest rate at which major banks *bid to borrow Eurocurrency deposits from other banks*; (1) unlike LIBOR, which is determined by the average interest rate which banks are willing to lend eurocurrency deposits, LIBID refers to the rate which banks bid to borrow

LIBOR rate

the average interest rate at which major banks *offer to lend Eurocurrency deposits to other banks*; (1) more specifically, it is the interest rate at which banks offer to lend funds to one another in the international interbank market how it works: (1) every day a group of leading banks submits the interest rates at which they are willing to lend to other finance houses: they suggest rates in 10 currencies covering 15 different lengths of loan, ranging from overnight to 12 months; (2) the most important rate is the three-month dollar Libor -- the rates submitted are what the banks estimate they would pay other banks to borrow dollars for three months if they borrowed money on the day the rate is being set; then an average is calculated

Federal funds rate

the interest rate on overnight loans of reserves kept at the Federal Reserve *from one US bank to another*; (1) the higher the federal funds rate, the more expensive it is to borrow money; (2) since it is only applicable to very creditworthy institutions for extremely short-term (overnight) loans, the federal funds rate can be viewed as the base rate that determines the level of all other interest rates in the U.S. economy

Discount rate

the interest rate on overnight loans of reserves kept at the Federal Reserve *from the Federal Reserve to other banks*; (1) the discount loans are intended to reduce liquidity problems and the pressures of reserve requirements: it allows the federal reserve to control the supply of money and is used to assure stability in the financial markets; (2) a decrease in the discount rate makes it cheaper for commercial banks to borrow money overnight, which results in an increase in the supply of money in the economy; (3) conversely, a raised discount rate will make it more expensive for the banks to borrow, and would thereby decrease the money supply