The overnight rate is the interest rate banks charge to each other for lending money overnight. At the end of a business day, banks usually end up with a surplus or deficit of funds. These funds can be shuffled between banks as needed to meet reserve requirements set by federal regulators and to address other needs. Banks that loan money charge an overnight rate paid by banks that need to borrow money.
During the course of the business day, banks both accept deposits and process withdrawals, transfers, and other types of financial activity. At the end of the day, they determine what their reserve requirements are, based on the total funds on deposit. If the bank does not have enough money on hand to meet the reserve requirement, it will need to borrow funds. Conversely, if it has excess funds, it can choose to invest or loan them.
Many banks have a periodic need for a short term loan of overnight funds. They can arrange to borrow the funds they need, paying the overnight rate to the lending bank. Sometimes government-set monetary policy determines the overnight rate or sets a range of acceptable interest rates. In other cases, banks work out their own agreements on the basis of the situation. Published overnight rates are usually averages of quoted rates that provide people with a ballpark idea of the rates currently being charged.
When liquidity is low, the overnight rate increases because less funds are available. As liquidity increases, overnight rates drop. This interest rate for short term financing can also have a ripple effect on interest rates for other kinds of financing, and in some cases, government interest rates may be pegged to the overnight rate, as it is viewed as an accurate reflection of current economic conditions because it fluctuates in response to market pressures.
Loans made between banks overnight are unsecured. Banks can also arrange other types of financing agreements with institutions that need long term loans and in some of these cases, collateral may be required for the loan to go through. Banks typically hold a variety of assets that can be used to back a loan.
People can find the overnight rate reproduced in a number of financial publications and on broadcasts dedicated to financial matters. In the United States, it is also known as the federal funds rate, and other nations may use other terms to refer to the overnight rate.