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August 28, 2017

Are some banks at risk of drowning in the NSFR river?

Graham Wade

Whilst the Net Stable Funding Ratio (“NSFR”) is not a big deal for the overall banking industry, certain business lines may have more challenges than the market anticipates.

The NSFR is one of the core planks of the post crisis regulatory reform (Basel 3). It requires banks to maintain a much more stable mix of funding than was the case before the crisis.

The reliance on short term wholesale funding that was exemplified by Northern Rock in the UK and Washington Mutual in the US will not be permitted.

In basic terms the NSFR requires banks to apply a stability factor to all of its assets and its funding sources and then ensure that its stability adjusted funding is sufficient to cover the liquidity profile of its assets. In general the rules aim to ensure the banks can weather 12 months of challenging funding conditions.

All funding with a maturity longer than 12 months is consider stable. For shorter dated funding the rules are intended to reflect behaviour observed in liquidity crises. For example retail deposits are considered to be very stable whereas wholesale funding is considered very flighty.

There is a lot of good sense in the NSFR and, coupled with the Liquidity Coverage Ratio (LCR) which ensures banks have cash to cover the next 30 days, our view is that there will be a dramatic reduction in the risk that a major bank gets caught in a liquidity squeeze.

However, as with all formula based rules there are some unusual features and cliff edge effects. As the following chart (EBA Dec 2015) shows there are also some clear policy choices that have been made in designing the rules. For example, a traditional retail deposit funded mortgage bank will have very few problems with NSFR which seems reasonable. However repo funding and derivatives are badly impacted even where there is no real liquidity risk created by the bank’s business. These two aspects largely explain the difference between the banks which comply and those with shortfalls.

The official line both from the regulators and most of the large banks is that NSFR is not a big issue and that they are already largely compliant ahead of implementation. Much of this confidence is based on industry studies by the ECB and Federal Reserve. For example in its December 2015 report which confirmed that the EBA is in favour of the NSFR the EBA cited the average NSFR was 104% (vs a 100% requirement).

This reminds us of the famous investment advice that a six-foot man can drown in a river which has an average depth of three feet.

Banks that have outsized prime or securities financing business are likely to be heavily impacted and the report also ignores the painful impact that UK ring-fencing will have (and similarly the equivalent Dodd-Frank and proposed European holding company rules).

The industry and consolidated banking groups will be fine but particular subsidiaries could find themselves with NSFR being a binding constraint causing them to further reduce balance sheet and client footprint. We have calculated that the marginal cost of balance sheet for an NSFR constrained bank will be in excess of 100bps precluding many low risk forms of financing.