Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching Bank Funding Costs
Transcript
- Lucas: If you've been following central bank communications lately, you might have noticed a subtle shift in what they're worried about. It's not just inflation and employment anymore — there's a growing focus on bank funding costs. Luna: You mean the cost banks pay to get their hands on cash? Deposits, wholesale funding, that sort of thing? Lucas: Exactly. And it's becoming a kind of early-warning system for financial stability. Think back to the regional banking turmoil in early 2023 — Silicon Valley Bank, Signature Bank, First Republic. A big part of that story was that those banks had a sudden, sharp increase in their funding costs. Luna: Right. They were paying more for deposits and wholesale funding at the same time that the value of their bond portfolios was dropping. A double squeeze. Lucas: Precisely. And central banks are now paying much closer attention to that squeeze — not just as a bank-by-bank issue, but as a systemic signal. If you're a central banker, you want to know: is monetary policy actually transmitting through the banking system, or are banks absorbing the rate hikes in ways that might collapse later? Luna: Yeah, it's a small gesture that keeps us independent. And it really does add up. Anyway, back to the funding cost question — what specific tool are central banks using to track this? Lucas: Well, in the US, the Office of Financial Research, or OFR, publishes something called the Bank Funding Cost Index. It's a daily measure of how much banks are paying for deposits and wholesale funding relative to risk-free rates. When that spread narrows, it means banks are having to offer more competitive rates to keep deposits, which eats into their margins. Luna: And that narrowing spread is exactly what we saw in 2023, right? Deposit rates lagged the Fed's rate hikes, but then depositors started moving money to money market funds, forcing banks to raise rates. Lucas: Yes. And the OFR index captures that. As of mid-2026, the spread remains relatively tight compared to historical averages, even though the Fed has paused. That suggests banks are still under some pressure, even if the acute crisis has passed. Luna: What about the European Central Bank? They use the Bank Lending Survey, right? But that's more about lending conditions, not funding costs per se. Lucas: True, but they also track the pass-through of their policy rate to bank lending and deposit rates. They have a metric called the 'cost of banks' funding' that combines deposit rates, interbank rates like EURIBOR, and bond yields. The ECB's Financial Stability Review regularly highlights how changes in funding costs affect the profitability and resilience of euro-area banks. Luna: And the Bank of England? They're big on SONIA, the Sterling Overnight Index Average. That's the benchmark for overnight funding in sterling markets. Lucas: Exactly. The BOE uses SONIA to monitor the cost of wholesale funding for banks. They also look at the spread between SONIA and the Bank Rate. If that spread widens unexpectedly, it can signal stress in the banking system. They've become much more vigilant about that since the 2022 gilt crisis. Luna: I remember that. The liability-driven investment blowup caused a sudden spike in funding costs for some UK banks. The BOE had to step in with emergency bond purchases. Lucas: That's a perfect example of why central banks are now treating funding costs as a real-time indicator, not just a lagging one. They want to see the plumbing before it starts leaking. And there's an interesting academic debate happening too. Luna: About whether central banks should incorporate funding stress into their monetary policy reaction function? As opposed to just using it as a financial stability tool. Lucas: Right. Some economists argue that if funding costs are rising because of monetary tightening, and that's causing banks to reduce lending, then the central bank is essentially getting a double dose of tightening — the policy rate itself plus the credit channel. So maybe they should take their foot off the gas a little when funding stress rises. Luna: But others say that would be a form of financial dominance — letting financial stability concerns dictate monetary policy, which could undermine the inflation target. Lucas: Exactly. And so far central banks have been reluctant to formally incorporate funding cost indicators into their policy rules. But they are certainly watching them more closely. The Fed, for example, now publishes a monthly report on the financial stability implications of bank funding conditions. Luna: And the Bank of International Settlements — the BIS — has been pushing for a global standard on monitoring funding costs. They argue that the 2023 episode showed how quickly a localized funding problem can become systemic. Lucas: That's a good point. The BIS has a working group on bank funding resilience. They're looking at whether the current regulatory framework — things like the Liquidity Coverage Ratio and Net Stable Funding Ratio — is enough to capture the kind of funding stress we saw. Luna: Because those ratios are based on assumptions about deposit stickiness and market access. But during a crisis, those assumptions can break down. Lucas: Right. Uninsured deposits, for instance, are assumed to be more flighty, but in practice even insured deposits can move if rates get competitive enough. So the BIS is asking whether the regulatory metrics need updating to reflect the new interest rate environment. Luna: And that brings us back to the central bank's role. They're not just setting interest rates anymore — they're managing the plumbing. Lucas: Which is why this topic matters even for non-bankers. If funding costs rise and banks tighten lending, that affects mortgage rates, business loans, consumer credit — the real economy. So a central bank that ignores funding costs risks having policy that's either too tight or too loose. Luna: Yeah, because the transmission mechanism can get clogged. If banks are hesitant to lend because their own funding is expensive, then a rate cut might not stimulate the economy as much as expected. Lucas: Exactly. That's the concept of the 'bank lending channel' of monetary policy. Central banks have known about it for decades, but they've historically treated it as a secondary consideration — something to worry about only during crises. The 2023 episode and the current high-rate environment have forced them to think about it more systematically. Luna: So what should a listener take away from this? If they see headlines about 'bank funding costs rising', what does that mean for their personal finances? Lucas: I'd say two things. First, it might mean that banks will offer higher deposit rates to attract funds — so that could be good for savers. But second, it could mean that loan rates stay higher for longer, and credit becomes harder to get. Small businesses, especially, feel that pinch. Luna: And for investors? If funding costs are rising, bank stocks might underperform, and sectors sensitive to credit — like real estate or small-cap industrials — could face headwinds. Lucas: Yes. And more broadly, if you see central bankers talking about funding conditions in their speeches, it's a sign that they're worried about financial stability risk. That could mean a more cautious approach to future rate moves. Luna: So it's a bit like watching the canary in the coal mine. Central banks are using it as an early indicator of whether their policy is working — or creating unintended consequences. Lucas: That's exactly right. And I think going forward, we're going to see more central banks publish their own funding cost indices, maybe even include them in their monetary policy reports. It's an evolving space, and one worth keeping an eye on. Luna: Well, Lucas, thanks for unpacking that. I feel like I have a clearer picture of what goes on behind the scenes at central banks. Lucas: Thanks, Luna. And to our listeners, if you want to stay informed on how central banks think, we'll be back with another episode soon. Thanks for listening.