Short Term Rate

By: EconomyWatch   Date: 9 September 2010

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The short term rate is the interest rate set for overnight transactions between financial institutions. In simple terms, it is the rate at which one bank borrows money from another at short notice.

Short term rates are interest rates on debt instruments or loan contracts, such as bank certificates of deposit, treasury bills or commercial papers, with maturities within a year. These rates are also known as money market rates.

 

Short Term Rate: How it Works

Overnight dealings occur between ‘market participants,’ one of them being a depository institution having excess reserves with the central bank and the other having a scarcity of funds. The short term rate for such inter-bank transactions is determined on a case specific basis, depending on factors such as the borrower’s credit worthiness and past record.

Short term rates are prone to changes in the rate at which the central banks lend money to different banks. This rate is altered by the sale and purchase of treasury securities. When a central bank buys securities, it increases the amount of money at the disposal of banks, resulting in a decline in the short term rates. On the other hand, the sale of securities reduces the cash reserves of a bank, thereby exerting upward pressure on the short term rates. This deters banks from borrowing funds.

 

Short Term Rates: Importance and Impact

Short term rates impact the prime lending rates at which banks lend money to their trustworthy customers, mainly corporations. The higher the interest rates, the less likely multinational corporations (MNCs) and other institutions are to borrow. They are, thus, unable to fund their growth plans. While extremely high short term rates have a ‘contraction’ impact on the economy, lower short term rates can trigger an ‘expansionary’ mode.

Against the backdrop of the global recession of 2008, several financial experts argue that it was an outcome of a prolonged phase of low short term rates, from 2002 to 2005. Low overnight rates for over a span of three years induced excessive liquidity in the market. As a result, banks started giving loans to even those borrowers who had a bad credit score or a history of credit default. They did not develop any plan to compensate the losses that might arise from loan defaults. Eventually, when people failed to pay back, banks had no credits left as a cushion.

 


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