What Are Overnight Fees?

Overnight Fees Defined

Overnight fees are the interest rates that banks charge one another for loans during a short period - often, throughout one night. Investors may see these fees passed onto them when trading on a margin account.

When you loan money to somebody else, you would often charge an additional fee - the interest rate. The same thing applies to banks. When banks lend money to each other, they will charge an interest rate. One specific kind of interest rate stands out in this case: the overnight fees/rates.

The overnight fees also apply to banks borrowing from central banks throughout the night.

Table of Contents

• How Overnight Fees Work

• Overnight Fees Explained with Examples

• Considering Overnight Fees

• What It Means for Retail Investors

How Overnight Fees Work

Banks are in the business of lending and borrowing money from their clients. To do so, banks will need a reserve of liquid assets. However, this reserve pool is not fixed but somewhat flexible due to deposits and withdrawals - general movements due to bank activities.

Generally, throughout the day, banks fulfil clients’ requests to 1) transfer funds from A to B, 2) deposit funds into a client account, 3) withdraw funds from a client account, 4) approve loans for clients.

These activities result in drastic changes in bank reserves, as large sums of money (in the millions) are moved from one bank to another, leaving some banks with shortages of reserves and some with surpluses.

Whereas the surpluses do not necessarily lead to immediate dangers to the banking system, shortages may be harmful if no actions are taken. To preserve the banking system, banks with surpluses would lend money to banks with shortages for a short time - primarily throughout the night - to meet a reserve requirement [1].

The reserve requirement is a threshold of the bank's reserves that must stay in the bank’s reserves and cannot be used in the bank’s activities. The funds must be kept there and remain there - and this rule is set for banks to fulfil any unexpected short-term obligations.

It is imaginable that some banks fall short of this threshold due to their various activities and cannot make this reserve requirement for the night. Bank’s can thus indeed lend money from other banks to fulfil this requirement.

Of course, when bank A lends money out like that, it would charge an interest rate—assuming that when the economy has lower liquidity, banks will charge a higher interest rate than when there is higher liquidity. In other words, when money is changing fewer hands, banks would charge a higher overnight fee than when money is changing hands frequently [2].

Why?

This is all because of a willingness to pay for the loans. Banks loaning out money to other banks find it harder to fulfil their short-term obligations because of lower liquidity in the economy, and lending banks, knowing this, may charge other banks higher overnight fees. Lending banks will gladly pay the overnight fees as long as they meet their goals.

Central Banks and Overnight Fees

Lending rates are supervised by the national central banks (Federal Reserve, Bank of Canada, Bank of England, etc.) or international central banks (European Central Banks).

Typically, the central banks would establish a target rate or a rate range as a goal. However, this target rate is not an order for banks to comply but remains a target and guideline for banks to follow [3].

The actual rates are ultimately set by the banks participating in the overnight market and the loans between banks to fill their bank reserves.

However, central banks may strongly encourage banks to keep the interest rates within a target range through open market operations. They may, for instance, purchase government bonds from banks. In this transaction,

• The central bank receives government bonds and sends cash

• The bank gets money and sends government bonds

What happens to the bank’s reserves?

Banks would have more cash and, therefore, more liquidity; they can fulfil their short-term obligations and do not have difficulty finding money to fill their reserves.

Overnight fees attached to short-term loans between banks will then be lower because the threshold and the incentive for banks to borrow money from each other are lower.

The opposite may also be true. The central bank might begin selling government bonds and withdraw cash and liquidity from the economy. In this transaction,

• The central bank receives cash and sends bonds

• The banks receive bonds and send cash

Liquidity in the economy decreases, and banks will find it harder to meet the obligations. Cash is harder to get - they are willing to pay a higher overnight fee as long as they can lend money from another bank to fulfil their reserve requirement. What happens then?

Interest rates set by banks for client loans also increase, resulting in the target rate set by the central banks to be achieved.

Overnight Fees Explained with Examples

Suppose that a Bank MNO handles its clients’ businesses throughout the day, receiving deposits from some clients while transferring funds from their reserves to other bank accounts on behalf of the clients.

There is a reserve requirement of 10% [new york fed reserve requirements]. By the end of business day, the reserves of Bank MNO drops below this reserve requirement of 10%. Therefore, they start looking to borrow funds from another bank, and since liquidity is low, Bank ITJ is the only bank willing to lend money to MNO - for an overnight fee of 1.5%.

In other words, when tomorrow comes, and business is starting up again with funds being deposited into MNO’s reserves, they should pay the money back to ITJ, including an interest rate of 1.5%.

Suppose that the economy’s liquidity is low - there is enough cash circulating between banks - but MNO still lacks funds in their reserves. They are looking to borrow money from other banks again. Bank ITJ still wants to charge a 1.5% overnight fee - which MNO politely refuses…

Instead, UUJ is willing to charge 0.9% as an overnight fee - which MNO gladly takes. Again, when the lending period is over, MNO pays back the amount of money they borrowed, including the overnight cost of 0.9%.

Now, these examples only display the workings of the overnight fees between two or three banks. However, a country’s financial system consists of various banks borrowing from and lending from each other - for a specific overnight fee.

The overnight fee across all these banks in that specific banking system is reflected in the interest rates charged to bank clients.

Considering Overnight Fees

Consumers

It may seem that overnight fees are mostly only relevant to bankers. However, this is not the case at all. Overnight fees are essential to any other financial sector since they are closely linked to interest rates and are a good indication of economic health.

As large financial institutions, banks would borrow and lend to each other at a cost known as the overnight fees. Banks will need to charge higher prices for any deposits made by other clients to compensate for these fees and still profit.

Therefore, overnight fees are not only a good indicator for general economic health but can be incredibly important for those who would like to purchase a house.

When the overnight fees increase between banks, the borrower would like to compensate for these increases by setting higher interest rates on the mortgages - and vice versa.

The same applies to deposits held by the banks - with increasing overnight fees, the interest rates funds at the banks will also increase.

Overnight rate plays a fundamental role in the economy, despite being relatively unknown - and precisely this overnight fee is what central banks target when they want to raise (or decrease) interest rates to achieve their expansionary and contractionary monetary policies [4].

Investors

Like consumers, investors being aware of the overnight fees have an edge in their trading activities because being aware of overnight fees is complementary to considering interest rates.

From our reading, we can see that central banks explicitly target overnight fees to achieve increases (or decreases) in interest rates to reach their monetary policy goals. These goals can be either expansionary or contractionary.

Expansionary Monetary Policy

In the case of slow economic growth, central banks may implement expansionary monetary policies to stimulate growth. The expansionary monetary policy reduces the overnight target rate and increases bond purchases, leading to increased cash and liquidity in the economy. Banks are then incentivised to borrow and lend more frequently, funnelling more money to consume, spend and invest in the economy.

The latter can be achieved, as banks are also lowering their interest rates, incentivising clients to loan more - and the banks receive their revenue through commissions and expansionary activities.

Contractionary Monetary Policy

The opposite is true when economic growth has been soaring and the central banks want to decrease growth. Central banks can thus achieve contractionary monetary by increasing the overnight target rate and increasing bond sales - leading to the withdrawal of cash and liquidity from the economy, incentivising the banks to borrow and lend less from each other (due to higher overnight fees), incentivising individuals to spend less and save more.

The actual interest rates will then be achieved over time by activities between banks and individuals.

Bullish or Bearish?

With that said, investors could assume that interest rates will eventually also rise with increasing overnight fees. Depositing money in that base currency provides more value, and the demand for that currency increases - this is bullish. However, this may be bearish for equities, as investors would instead deposit their money to receive (almost) risk-free returns.

On the contrary, investors could assume that with decreasing overnight fees, interest rates could potentially fall. Depositing money in that base currency provides less value, and the demand for that currency decreases - leading to bearish biases. Instead, it may be bullish for equities, as investors would instead invest their money in the stock market to receive returns.

What It Means for Retail Investors

Interest rates may be the talk of the economic town, but overnight fees, although relatively unknown, are the backbone of any interest rate increase or decrease. Overnight fees are the costs of borrowing from another bank for a short period - one night.

They are set by the banks and revolve around cash and liquidity reserves - because banks in many countries need to conform to a reserve requirement.

However, the overnight fees often are coordinated according to the target rates set by the central banks. As such, when overnight fees increase, it could become a strong signal for further interest rate increases and vice versa.

Being aware of the overnight fees and their impact could provide an investor, trader or consumer alike with an edge!

Article Sources

• [1] Bank of Brazil. “Reserve Requirements.” Accessed 10 August 2021.

• [2] Bouwman, C. “Liquidity: How Banks Create It and How It Should Be Regulated.” The Oxford Handbook of Banking. Oxford University Press, Oxford, 2014. Accessed 10 August, 2021.

• [3] Federal Reserve. “Open Market Operations.” Accessed 10 August 2021.

• [4] Educators Financial Group. “It pays to understand the Bank of Canada overnight rate increase.” Accessed 11 August 2021.