Bank Funding Cost and Liquidity Supply Regimes
Note: This paper and appendix (see further below) have been updated as of 25 November 2020. It was originally published under the title "A New Indicator of Bank Funding Cost".
Focus
This paper describes the construction of a new indicator of bank funding stress in both dollars and euros. The Great Financial Crisis of 2007-09 has changed the way money markets function, and banks have since been subject to rollover risk. In other words, there is a difference between the bank offered rate at a given tenor (ie the frequency of payments agreed between counterparties) and the rollover of overnight interest swap rates with the same maturity. While this rollover risk is typically measured by the spot IBOR-OIS spread, we obtain a more complete picture of banks' current and expected funding stress by measuring the market expectation of future IBOR-OIS spreads.
Contribution
We build forward IBOR-OIS spreads, which we call forward funding spreads (FFS), using transaction data from dollar and euro interest rates of various maturities. Our FFS are consistent in terms of the underlying tenors associated with the interest rate contracts. This is important because different frequencies of payments imply different underlying rollover risks. These FFS, which are daily indicators of expected funding stress, are made available online in an appendix to this paper.
Findings
We show that FFS are useful in at least two respects. First, they provide central banks with an indication of the market perception of bank funding stress and its persistence. In crisis times, the FFS is typically narrower than the spot IBOR-OIS, which is consistent with market participants' expectation that funding stress will be short-lived. We actually characterise liquidity regimes (crisis, moderate and abundant) that are correlated with the levels of excess liquidity supplied by either the Federal Reserve or the ECB. We show, in particular, how liquidity regimes strongly impacted the FFS's response to the Covid-19 pandemic on both sides of the Atlantic. Second, FFS are also better predictors of economic and banking activity than alternative spreads either on rollover risk or on credit risk. This is consistent with the view that bank funding stress can influence macroeconomic outcomes only if market participants expect them to persist.
Abstract
Designing operations for liquidity support requires central banks to properly measure and monitor bank funding risk in real time. We construct a new indicator of rollover risk for banks, called the forward funding spread. By accounting for market participants' expectations of how funding costs will evolve over time, it serves as a better signal of the change in the stance of monetary policy than the usual spot InterBank Offered Rate-Overnight Interest Swap spread. Our indicator helps to contrast three liquidity regimes, which coincide with the levels of excess liquidity supplied by central banks.
JEL classification: E32, E44, E52
Keywords: bank funding cost, bank credit spreads, liquidity supply regimes, multicurve environment, economic activity predictability
