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What is the overnight rate?

Overnight Rate Definition

The overnight rate definition refers to the interest rate at which banks lend and borrow money from each other in the overnight market. The main goal of such interbank activities is to maintain the reserve requirements of central banks. In addition, banks and other financial institutions may borrow money to meet short-term cash needs when, for instance, their customers plan to withdraw big cash in the coming days.

The overnight rate is generally set by the central banks. For example, the Federal Reserve in the United States and the Bank of Canada set overnight rates according to their monetary policies and economic growth targets.

Typically, the overnight rate is the lowest interest rate available. It is only accessible to the most creditworthy institutions.

Where have you heard about the overnight rate?

For those not interested in banking activities and economic growth drivers, the term may be unfamiliar as it receives little or no media coverage. Bankers and individuals related to finance, however, are likely to know that the overnight rate is one of the most important components of economic activities and overnight lending between depository institutions.

What you need to know about the overnight rate

During the course of a business day, banks exchange money with each other, as well as with institutional and retail clients. At the close of a working day, a bank may have a shortage or surplus of cash funds. For that, the overnight rate exists.

Those banks that experience a surplus often lend money overnight to banks that experience a cash deficit to maintain their reserve requirements. This ensures that the banking system remains stable and liquid.

As it is influenced by a nation’s central bank, the overnight rate definition suggests that it can be used as a good measure of the prevalence of liquidity in the economy.

In conditions of narrow liquidity, overnight rates rise dramatically as loans are more difficult to come by. They also rise when there is a lack of confidence in banks, as witnessed in the infamous 2008 financial crisis. When liquidity increases and loans are more readily available, the overnight rate falls.

As a result, the overnight rate is considered a good indicator of a country's overall economic health and the banking system in particular.

Central banks have the power to change the overnight rate based on their financial and economic growth targets. If the economy is growing at a slower pace than expectated, the central bank could lower the overnight rate to bolster growth. Conversely, the central bank can increase the overnight rate in case of rising inflation.

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