Overnight rate in the context of Interest rate

The interbank lending market is a market in which banks lend funds to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate (also called the overnight rate if the term of the loan is overnight). A sharp decline in transaction volume in this market was a major contributing factor to the collapse of several financial institutions during the 2008 financial crisis.

Banks are typically required to hold reserves of an adequate amount of liquid assets, such as cash, to manage any potential bank runs by customers. To remain compliant, those banks with less than the required liquidity will borrow money and pay interest in the interbank market, while those with excess liquid assets will lend money and receive interest.

The overnight market is the component of the money market involving the shortest term loan. The overnight market is primarily used by banks and other financial institutions. Lenders agree to lend borrowers funds only "overnight", i.e., the borrower must repay the borrowed funds plus interest at the start of business the next day. Given the short period of the loan, the interest rate charged in the overnight market, known as the overnight rate is, generally speaking, the lowest rate at which banks lend money.

Most of the activity in the so-called overnight market in fact occurs in the morning immediately after the start of business for the day. Banks and financial institutions analyse their cash reserves on a daily basis, and assess whether they have an excess or a deficit of cash with respect to their needs. More specifically, deposit-taking financial institutions (such as banks) begin with forecasting the institution's and its clients' liquidity needs over the course of that day. If this projection is that the institutions' clients will need more money over the course of the day than the institution has on hand, the institution will borrow money on the market that day. On the other hand, if the analyst projects that the institution will have surplus money on hand beyond that needed by its clients that day, then it will lend money on the overnight market that day. In this context, the term "overnight" means that the cash borrowed is repaid the following day.