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In New Zealand, there is the OCR, which is the rate at which retail banks borrow from the central bank (https://www.nzherald.co.nz/nz/news/video.cfm?c_id=1&gal_cid=1&gallery_id=213767)

However, banks also borrow and lend money to one another in the inter-bank network. When banks lend out to normal people (e.g. taking loan out for a car), is the rate determined by the rate of the inter-bank network? In other words, does the inter bank lending market drive the interest rates (mortgages etc) - are the interest rates of mortgages determined by adding a premium to the inter bank market rates?

Edit: I should have phrased the message on the bounty differently. I didn't phrase my question correctly to address what I was confused about before.

Christopher U
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  • Your second video (starting at 0:58) suggests that the Central Bank pays the OCR on deposits by commercial banks and charges slightly more (it says half a percent more) than the OCR for borrowing by commercial banks; this encourages commercial banks to lend to each other somewhere in this corridor. – Henry May 09 '20 at 01:41

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The first thing to understand is that banks lend to each other as part of the normal functioning of the banking system. Banks transfer money between themselves based on customer transactions, and banks that end up losing flows typically borrow from banks with the excess. They do this on an overnight basis, since the flows can reverse the next day.

Central banks have a policy rate, the details of which depend upon the country. Typically, it undertakes actions to keep the private sector interbank lending rate near this target. It does not necessarily have to lend money to banks itself to do this.

So is the official cash rate set by the central bank (or equivalent central bank rates overseas) the rate which banks lend to one another, or is it the rate the central bank lends to retail banks?

As explained above, the central bank announces a target for the overnight rate between banks. There are a number of ways to achieve this objective (repos, outright purchases of bonds, borrowing/lending, discounting bank assets). If you wish, you can search for those terms individually, or consult central bank websites for primers.

And how does this ultimately affect normal people borrowing from retail banks?

Lenders compare the risks of potential borrowers, and charge a yield premium - a spread - for riskier borrowers. Lending to the central government is normally the least risky form of lending, and then lending to other banks. The implication is that all other forms of lending are riskier, and so they borrow from banks at a positive spread to the interbank rate. This means that the interbank rate is the benchmark for other borrowers, and explains why central banks guide the interbank rate.

(In the midst of a crisis, almost all forms of lending can be viewed as risky, and lending rates can be quite unstable. Central banks need to take actions to eliminate these credit stresses.)

Brian Romanchuk
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  • Thank you for the insights! So by saying that all other forms of lending are more risky than lending to the govt and to the other banks in the country, that means the other retail/consumer interest rates would almost certainly be higher than the policy interest rate? – Tan Yong Boon May 17 '20 at 05:22
  • So it seems, they all do turn out to be higher than the policy rate: https://www.bloomberg.com/markets/rates-bonds/consumer-interest-rates – Tan Yong Boon May 17 '20 at 05:23
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    Unless there’s some other effects in play (e.g., tax, regulations), it makes little sense to lend at a lower rate to a riskier borrower. In particular, banks would lose money if they lent to consumers at a lower rate than which they can borrow. Meanwhile, consumer lending is the most expensive to service, so consumer borrowing rates tend to be the highest, on a risk-adjusted basis. – Brian Romanchuk May 17 '20 at 16:13