It's a matter of trust: Financial conditions tighten on stability risks

REAL ECONOMY BLOG | March 15, 2023

Authored by RSM US LLP

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.

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.

This article was written by Joseph Brusuelas and originally appeared on 2023-03-15. Reprinted with permission from RSM US LLP.
© 2024 RSM US LLP. All rights reserved. https://realeconomy.rsmus.com/its-a-matter-of-trust-financial-conditions-tighten-on-stability-risks/

RSM US LLP is a limited liability partnership and the U.S. member firm of RSM International, a global network of independent assurance, tax and consulting firms. The member firms of RSM International collaborate to provide services to global clients, but are separate and distinct legal entities that cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party. Visit rsmus.com/about for more information regarding RSM US LLP and RSM International.