Trust is the lubricant that makes modern commerce possible. It facilitates an uninterrupted operation of finance that allows firms to fund expansion and modern economies to operate efficiently. It reduces transaction costs, minimizes frictions and creates the conditions for broader and deeper forms of economic interaction.
Evolving financial conditions and key risk metrics show an erosion of trust as concerns about counterparty risk multiply.
Ask yourself this question: Do you get a receipt after buying gas or withdrawing money from an ATM?
For many, the answer is no.
Why is that?
Trust in the system.
But in the banking sector, that trust is eroding, albeit on a grander scale. Evolving financial conditions and key risk metrics show this erosion as concerns about counterparty risk multiply. Regional banks are tapping wholesale funding at the Federal Home Loan Banks as private sector financial institutions pull back from lending.
The fragile nature of trust in modern finance demands that we follow a number of metrics that reflect risk in the system.
Here we present our RSM US Financial Conditions Index, along with the forward rate agreement and the overnight index swap rate, or the FRA/OIS spread, as two key barometers of trust in the financial system.
As of Wednesday morning, the RSM index was at 1.4 standard deviations below neutral, indicating increases in volatility and risk priced into financial assets, with the prospect of diminished investment and economic growth.
U.S. markets are attempting to come to terms with the result of relaxed oversight of the banking industry, the vulnerability of small and midsize banks with exposure to interest-rate risk, and the bursting of the cryptocurrency and tech bubbles. (On Tuesday morning, Meta said it would cut 10,000 jobs and scrapped plans to hire 5,000 more.)
The weekend collapse of a third regional U.S. bank and concerns of contagion in Europe are the immediate cause of a reassessment of risk in the equity and money markets.
That spilled over into the bond market, where a shift in expectations regarding economic growth precipitated a drop in both two-year and 10-year yields.
The instability in the money markets is particularly distressing for the business community, which depends on money markets for day-to-day operations.
Another metric we follow that reflects basic counterparty risk and is our preferred barometer of trust within the banking system is the FRA/OIS spread.
A forward rate agreement swaps future fixed interest payments for variable ones. The overnight index swap is derived from contracts in which investors swap fixed and floating rate cash flows. The higher the FRA/OIS spread, the greater the perception of risk.
An important rate is the secured overnight financing rate, or SOFR, which is the benchmark that underscores interest rates on trillions of dollars of financial instruments like credit cards, auto loans and mortgages.
Movement in benchmarks
The FRA/OIS spread has increased notably in recent days and now reflects a 57 basis-point difference, which is up from a near zero reading just days ago. While nowhere near 2008 levels—this is not yet a 2008-type of crisis—it is approaching levels observed during the pandemic era.
While the surge in the FRA/OIS spread signals increased expectations of risk, volatility in short-term credit spreads signals uncertainty regarding economic growth and the availability of short-term loans that permit day-to-day business operations.
All of these are consistent with growing counterparty risk, which could make interbank lending more risky.
Since banks would take losses if other banks fail or are seized, they will demand higher interest rate payments to lend to one another, which causes an increase in the FRA/OIS spread.
In past episodes of financial stress, distress in the money markets has forced central banks to become the lenders of last resort, providing liquidity and avoiding a commercial market freeze-up.
That is what the Federal Reserve, working with the Treasury Department and Federal Deposit Insurance Corporation, did over the weekend by providing an implicit guarantee of all deposits in the Bank Term Funding Program.
Should the problems inside the European Union banking system expand, we expect that European and Swiss monetary authorities will take whatever action is necessary to put a floor under their financial system.
This puts the onus on the European Central Bank decision on Thursday. The ECB had committed to a 50 basis-point hike in its policy rate, and the Federal Reserve was expected to hike its policy rate by 25 basis points at its meeting on March 22.
But the rapidly evolving conditions in financial markets could easily deteriorate to the point where those central banks pause their efforts to restore price stability.
The takeaway
Central banks must strike a careful balance between the need to restore price stability and re-establishing financial stability.
Do they risk allowing inflation to continue, which would hurt consumers and the economy? Or do they see the recent distress in the banking sector and the markets as a greater risk to the financial health and functioning of the economy?
Even before the events of the past few days, it had become difficult to dissect market actions. While the markets have consistently discounted the Fed’s and ECB’s intentions to combat inflation, the markets have taken notice of potential bank failures seriously.
It’s a matter of trust.
