Wednesday, March 30, 2016

Should Bank Repo Activity be Exempt from the NSFR?

Protecting Repo Markets from NSFR's Unintended Consequences

Banks drive economic growth by providing financing for consumers and businesses. To provide this vital financing, their business models rely heavily on cheap and efficient maturity transformation made possible, in part, through short-term financing. With an implementation date less than one year away, banks and their industry groups are raising the alarm about how the Basel III Net Stable Funding Ratio (NSFR) may drive up severely the cost of short-term financing, thereby stalling the engines of economic growth, harming global liquidity, and increasing rather than reducing systemic risks.[1] The International Capital Markets Association (ICMA) published a paper in March of 2016 detailing these concerns and laying out some recommendations it believes would help to calibrate the final NSFR to “smooth its effects on repo and collateral markets” while maintaining the ratio’s goal of enhancing long-term financial stability.  

The NSFR establishes a minimum acceptable amount of stable funding based on the liquidity characteristics of an institution’s assets and activities over a one-year horizon.[2] This requirement will:

  1. force banks to hold more stable sources of operational funding by reducing their short-term wholesale funding and holding more deposits; 
  2. decrease the ability of banks to raise funding by issuing commercial paper of up to 270 days maturity; and 
  3. extend the amount of long-term debt being held compared to hard to finance assets.

The NSFR is designed to be a tool to move banks to more stable sources of funding that are less vulnerable to shocks. But, the ICMA says the new requirement will channel bank activities toward those that favor the NSFR’s long-term stable funding requirements, driving up demand for preferred longer-term funding instruments while starving activities requiring short-term funding. Banks will be required to hold long term stable funding against their short-term repo activities, and ICMA says this will necessarily drive up the cost, harm overall liquidity, and create shortages in the collateral markets.

 “Given the role of repo and collateral markets at the heart of the financial system, [the NSFR] would have negative implications for the smooth functioning of broader financial markets — which would, in turn, lead to increased costs and risk for market participants, including those corporates and governments borrowing to finance their economic needs. At the same time, there would also be a detrimental impact on the effectiveness of many of the measures put into place to improve the stability of the financial system, dependent as they are on high-quality collateral.”

But ICMA seeks ways to mitigate the potential damage the NSFR could do to repo and collateral markets without harming the overall goal to enhance long-term financing stability. ICMA believes the best way to adapt the NSFR “to better smooth its effects on repo and collateral markets” would be to exempt securities financing transactions (in this context, of six-months or less) such as repo from the NSFR calculation:

"To avoid driving essential cash and collateral management activity out of the money markets, which would leave central banks having to intermediate liquidity, the ICMA ERCC believes there is a need to effectively exempt short-term activity from the NSFR imposition of an element of long-term funding costs.The benefits of making such a market sensitive adaptation would be felt by borrowers, both corporate and governmental, and investors; and would help underpin the effective functioning of other regulations designed to deliver increased financial stability."

ICMA also notes that repo markets are already under a great deal of stress as a result of the leverage ratio (LR), and adding stress arising from of the NSFR may not be necessary. According to the authors, these short-term cash and collateral activities are already governed by the liquidity coverage ratio (LCR). Meeting LCR requirements, the authors say, has caused leading banks to manage actively their liquidity needs out to at least 90 days, reducing significantly concerns about funding stability that underpin the NSFR.[3]

Consequently, the paper recommends “full and deep impact studies” of the potential effects of the NSFR before its full implementation in 2018. In the meantime, however, ICMA recommends the NSFR should be recalibrated by: 

  1. refining the applicable ASF/RSF proportions in order to rebalance their asymmetry driven behavioral effects (including potentially identifying more detailed specific treatments for special asset types such as HQLA, or in relation to desirable financing activities such as matched book repo facilitation); and
  2. relaxing the conditionality for netting securities financing transactions, and/or allowing for a more expansive interpretation of interdependent assets and liabilities, in order to allow more scope for mitigation of the impacts of NSFR.


By design, through the available stable funding (ASF) and required stable funding (RSF) weightings, the NSFR discourages short-term trades (i.e., less than one year).  The ratio affects repos (which generate ASF gains) and reverse repos (which generate RSF needs) differently when the duration of the trade is less than six months, creating asymmetries depending on the type of entity and collateral involved in the transaction. The ICMA quantifies this asymmetry between repos and reverse repos depending on the type of counterparty and the residual maturity of the transaction.  Then, the authors support their recommendations by analyzing the effects of this asymmetry on the available stable funding (ASF) and required stable funding (RSF) components of the ratio.  The NSFR fails to take into account these asymmetries. And the ICMA's recommendations take a targeted approach to mitigate the effects of the NSFR on repos and collateral while leaving the ratio intact for areas where it may actually be necessary and useful.  


ICMA also sees some problems associated with the implementation of the NSFR.  The authors point out that the ratio is not being rolled out in a vacuum, noting differences between jurisdictions and the banks themselves that may hamper the smooth implementation of the NSFR creating an uneven playing field, including:

  • Different timing pressures for adoption of the ratio from bank to bank and jurisdiction to jurisdiction; and
  • Application of the NSFR to different corporate structures, especially if not all regulatory authorities adopt consistent approaches regarding the application of the NSFR at group, as opposed to individual entity, level.

According to ICMA, their recommendations would address or at least mitigate these implementation difficulties.  

Balancing Vital Goals

The NSFR, the final plank in the Basel III framework, furthers vital policy goals: limiting banks’ overreliance on short-term wholesale funding, encouraging better assessment of funding risk across all on- and off-balance sheet items, and promoting funding stability.  If taken seriously, these recommendations proposed by ICMA could potentially balance these policy goals with the equally vital objective of avoiding unnecessary disruptions to healthy, vibrant, and well-functioning repo and securities lending markets. 

The full text of ICMA’s report is available via:


[1] The NSFR was first proposed by the Basel Committee (BIS) in 2009 and included in the 2010 Basel III Agreement. BIS issued a consultation on the NSFR in January 2014, and final guidelines in October 2014.  At present, the NSFR is in an observation period until January 1, 2018 when it becomes a minimum standard under the Basel liquidity risk framework.

[2] The NSFR is defined as the amount of available stable funding (ASF) relative to the amount of required stable funding (RSF). The ASF is defined as the portion of capital and liabilities expected to be reliable over the time horizon considered by the NSFR, which extends to one year.  NSFR = ASF (Available Stable Funding) ÷ RSF (Required Stable Funding) ≧ 100%

[3] The LCR requires banks to employ a minimum amount of capital to fund their assets and penalizes transactions that involve large amounts of low-return securities, such as repos.