Tuesday, December 30, 2014

A Cloud of Doubts About the Net Stable Funding Ratio

The NSFR is Flawed, Yet Still Fixable

In October 2014, the Bank for International Settlements (BIS) adopted final standards for the “net stable funding ratio” (NSFR), the last plank in the Basel III banking reforms.  The NSFR was first proposed in 2009, and elicited much concern from the industry regarding its potential effects on financial market functioning and the economy; so much so that BIS reproposed a new version in January 2014.  The final NSFR retains the structure of the January 2014 consultative proposal, but with changes giving national regulators more scope to exempt particular assets from the general funding requirement if that asset is linked to a particular funding source, and including rules for funding short-term interbank loans, derivatives trades, and assets posted as initial margin on derivatives contracts.  Despite these changes, there still remains what may be considered widespread concern in the financial industry that the final NSFR is improperly focused, subject to measurement deficiencies, and may lead to higher transaction costs in equity markets and beyond. 


The “net stable funding ratio” (NSFR) itself is the ratio of a firm’s available stable funding (ASF) to its required stable funding (RSF) and seeks to measure the amount of longer-term and stable sources of funding employed by an institution relative to the liquidity profiles of the assets funded, taking into account the potential for contingent calls on funding liquidity arising from off-balance sheet commitments and obligations.  BIS devised the NSFR to complement the liquidity coverage ratio standard (LCR) and reinforce other Basel III standards by encouraging banks to make structural changes in their liquidity risk profiles, moving away from short-term funding mismatches and toward more stable, longer-term funding of assets and business activities. 

 

According to  Stefan Ingves, chair of the Basel Committee, the NSFR is the necessary final step in the BIS regulatory reform agenda:

 


"A key lesson from the crisis has been the need to prevent overreliance on short-term, volatile sources of funding. . . The NSFR does this by limiting the use of volatile short-term borrowings to fund illiquid assets."


"In finalising the standard, the committee has essentially completed its regulatory reform agenda, undertaken to promote a more resilient banking sector following the financial crisis."


The long proposal and reproposal process has given the industry ample time to voice their concerns, and with some beneficial effect.  In response to industry comments, BIS produced a January 2014 draft with more favorable treatment of operational, retail, and small business deposits and retail and small business loans, and harmonized the categorization of assets’ liquidity under the NSFR with the LCR’s High Quality Liquid Asset definitions.  While the final rules retained these improvements, they also introduce a host of other thorny issues.  

 

 

 

 

  • Repo transactions are treated more harshly under the final NSFR.  Under the final rule, repo transactions are assigned a higher weighting (10% RSF) than in the earlier proposals (0% RSF).

 

 

 

 

 

  • The incorporation of off-balance sheet exposures in the final NSFR creates a number of new ambiguities.  The final rules fail to define adequately a number of key terms necessary to determine which off-balance sheet exposures are relevant, and which may be excluded.  Also, the final rules delegate assignment of RSF percentages to individual national regulators, introducing the potential for inconsistency, confusion, and regulatory arbitrage.

 

 

 

 

  • Treatment of derivatives under the final NSFR lacks clarity. Under the final rules, derivative assets are valued based on replacement cost or net replacement cost, which while appropriate, introduces additional ambiguities because of myriad complications resulting from the application of a simple netting model and the vagueness of the introduced term, “regulatory netting."  

 

 

 

 

  • The NSFR could increase costs and cause widespread problems in the equities markets.  The application of the NSFR necessarily increases the funding cost for banks’ equity market intermediation activities, and could also potentially increase rather than decrease systematic risk by forcing some of these activities into the largely unregulated shadow banking system.   Increased funding costs in equities markets could also have knock-on effects in the swaps, forwards, options, short selling, and securities lending markets, likely limiting these activities or driving some of them into the shadow banking system as well.  

 


The final plank in the Basel III framework furthers very important 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.  However, it is important to balance these policy goals with the equally vital objective of avoiding unnecessary disruptions to healthy, vibrant, and well functioning equity markets.  With a final adoption date of January 1, 2018, there is still time to fine-tune the NSFR to make it more focused and effective, avoiding unintended risk, and assuring efficient and cost-effective access to these markets to end-users.

 

 

 

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