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.
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.
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.
The cost of bank funding on money markets is typically the sum of a risk-free rate and a spread that reﬂects rollover risk, i.e., the risk that banks cannot roll over their short-term market funding. This risk is a major concern for policymakers, who need to intervene to prevent the funding liquidity freeze from triggering the bankruptcy of solvent financial institutions. We construct a new indicator of rollover risk for banks, which we have called forward funding spread. It is calculated as the diﬀerence between the three-month forward rate of the yield curve constructed using only instruments with a three-month tenor and the corresponding forward rate of the default-free overnight interest swap yield curve. The forward funding spread usefully complements its spot equivalent, the IBOR-OIS spread, in the monitoring of bank funding risk in real time. First, it accounts for the market participants' expectations for how funding costs will evolve over time. Second, it identiﬁes liquidity regimes, which coincide with the levels of excess liquidity supplied by central banks. Third, it has much higher predictive power for economic growth and bank lending in the United States and the euro area than the spot IBOR-OIS, credit default swap spreads or bank bond credit spreads.
JEL classification: E32, E44, E52
Keywords: bank funding risk, bank credit spreads, liquidity supply regimes, multicurve environment, economic activity predictability
Read the full paper at: https://www.bis.org/publ/work854.htm