Funds are transferred through the purchase and sale of money market instruments—highly liquid short-term debt securities.
To meet reserve requirements and manage day-to-day liquidity needs, banks buy and sell short-term uncollateralized loans in the federal funds market.
These are certificates issued by banks which state that a specified amount of money has been deposited for a period of time and will be redeemed with interest at maturity.
Funding liquidity risk captures the inability of a financial intermediary to service its liabilities as they fall due.
This type of risk is particularly relevant for banks since their business model involves funding long-term loans through short-term deposits and other liabilities.
When interbank markets are dysfunctional or strained, banks face a greater funding liquidity risk which in extreme cases can result in insolvency.
Thus, conditions in the unsecured interbank market can have wide-reaching effects in the financial system and the real economy by influencing the investment decisions of firms and households.
However, it eventually lost its benchmark status to Libor due to pricing volatility caused by periodic, large swings in the supply of bills.
Central banks in many economies implement monetary policy by manipulating instruments to achieve a specified value of an operating target.
Successful monetary policy transmission thus requires a linkage between the Fed's operating targets and interbank lending reference rates such as Libor.
During the 2007 financial crisis, a weakening of this linkage posed major challenges for central banks and was one factor that motivated the creation of liquidity and credit facilities.
Thus, conditions in interbank lending markets can have important effects on the implementation and transmission of monetary policy.
Strains in interbank lending markets became apparent on August 9, 2007, after BNP Paribas announced that it was halting redemptions on three of its investment funds.
At the following FOMC meeting (September 18, 2007), the Fed started to ease monetary policy aggressively in response to the turmoil in financial markets.
In the minutes from the September FOMC meeting, Fed officials characterize the interbank lending market as significantly impaired: “Banks took measures to conserve their liquidity and were cautious about counterparties’ exposures to asset-backed commercial paper.
In September 2008, when the US government decided not to bail out the investment bank Lehman Brothers, credit markets went from being strained to completely broken and the Libor-OIS spread blew out to over 350bps.
Thus, adverse selection may have exacerbated strains in interbank lending markets once Libor rates were on the rise.
The market environment at the time was not inconsistent with an increase in counterparty risk and a higher degree of information asymmetry.
In the second half of 2007, market participants and regulators started to become aware of the risks in securitized products and derivatives.
Another possible explanation for the seizing up of interbank lending is that banks were hoarding liquidity in anticipation of future shortages.
This meant banks had fewer sources of funds to turn to, although an increase in retail deposits over this period provided some offset.
After the near collapse of the commercial paper market, however, firms took advantage of this insurance and banks had no choice but to provide the liquidity.
Previously it was the British Banker's Association average of interbank rates for dollar deposits in the London market.