Overnight loan means that the
amount of money that one bank give to other bank to maintain adequate amount of
liquid assets, such as cash to manage the potential withdrawals and maintain
reserve in central bank. If one bank has shortage of money to fulfill the
withdrawals requirement it borrow money from other bank which has surplus amount
of money from targeted fraction which is impose by central bank to fulfill that
requirement.
For banks both the situation are harmful (shortage and surplus of money).Because
if the banks has not sufficient amount of money to fulfill the central bank
requirement or potential withdrawals, the bank will be liquidate or bankrupt
because it is necessary for every bank to maintain the specific friction amount
of money in central bank as reserve as well in its own to fulfill the potential
withdrawals requirement. In case of surplus of money from targeted reserve, the
bank give it to other bank which has shortage of money to earn interest and
became financially strong.
The maturity duration of interbank loan is very short it may be one week or less
the majority being overnight but it also depends on baking transaction. The rate
of interest is determine by federal bank .But also depend on money that is
available on market and the length of borrowing. If money in market is available
in large amount or in case of inflation the interest rate for overnight loan
will be high. Similarly if duration is long the rate will be high. So it depend
on term and condition of banks for borrowing and lending of money.
Overnight loan or interbank transaction is basically a support for the bank
which has shortage of reserve in central bank to overcome that shortage bank
borrow short term loan from other bank in this way they get support from other
bank to maintain the reserve.
Overnight loan is also source of funding at low risk because when banks lends
long term loan through short term deposit and other liabilities, the bank face
shortage of money so to overcome that shortage bank borrow from other banks at
low risk. It is low risky because central bank involve in transaction and loan
rate also determine by central bank as benchmark. So benchmark help to control
the interest rate in overnight loan.
Central bank in many economies control the monitory policy to achieve the
operating targets. Through different variables central bank control monitory
policy such as reserve requirement, interest rate of central bank, balance sheet
etc. So through these ways central bank influence the overnight loan. And make
it easy for bank to gets loan from other banks to maintain their Federal Reserve
and potential withdrawals requirement.