Net Stable Funding Ratio: Two Short Papers with Significant Impact

The Basel III paper,
‘The Net Stable Funding Ratio’
(NSFR) and the follow-up consulting document,
‘Net Stable Funding Ratio Disclosure Standards’
describe the way this new liquidity measure will be calculated, applied and reported.

The new measure must be implemented by 1 January 2018. But in reality, most firms will look to do so much earlier, driven by market expectations. As with liquidity credit ratio – or LCR – reporting, there will be a reputational risk for any firm that waits that too long to implement NSFR reporting. The LCR was a measure that firms were reporting long before the 2015 deadline. Firms understood it was another way of saying we have enough liquidity and enough capital.

As your firm prepares to begin reporting on NSFR, here are some things you will want to consider:

ASF and RSF Calculations

As a result of this change, firms are now required to ensure that the amount of available stable funding (ASF) is always greater than the required stable funding (RSG). Both amounts are calculated over a one-year time period.

ASF is calculated by weighting the capital and liability items in a firm’s balance sheet. Regulatory capital has a weight of 100%, indicating that capital is a good source of long-term funds. Funding, including deposits, with non-financial corporates of less than one year has a weighting of 50% – reflecting that this is a weaker source of longer-term funding.

RSF is calculated by looking at the asset side of a firm’s balance sheet, and similar to the ASF, applying weightings. Coins, banknotes and reserves at central banks receive a 0% weighting, indicating that no funds are required for these assets. High quality liquid assets with a maturity of between six months and one year receive a weighting of 50%. Encumbered assets of one year or more and net derivative assets both receive a weighting of 100%, indicating that financial firms should fully fund these balances.

The Role of the NSFR

The NSFR is designed to reduce a financial firm’s dependence on short-term funding, being used to fund longer-term assets and commitments. The need for such a measure was highlighted during the 2007-09 financial crisis, when several failures were attributed to the non-availability of shorter-term funding during that period – despite many of these entities meeting the regulatory capital requirements. NSFR has been designed to continue to allow banks to perform maturity transformation (borrowing short-term and lending long-term), which is a crucial economic function of the banking sector. It does, however, impose limits on the amount of maturity transformation, which will serve to dissuade certain business models.

Many will see the similarity between the calculation of the LCR and the NSFR, particularly in relation to how the two metrics are calculated. NSFR and LCR are complementary, with the new NSFR paper using many of the definitions established by the LCR. There are, of course, key differences in the way in which they are to be used. The LCR is a short-term 30-day measure, designed to ensure that a financial firm can withstand a severe period of stress. Key to this idea is that firms should have a buffer of high quality liquid assets to call upon, usually in the form of government bonds that can be easily converted to cash.

The NSFR, in contrast, has the objective of reducing the mismatches in funding over the one-year term between maturing assets and liabilities, thereby reducing the level of rollover risk. So, the impact of the NSFR is more structural, whereas the LCR is more tactical.

Challenges to the NSFR

There is room for some national discretion, allowing the supervisory authorities to adjust some of the factors, if necessary, to align their sector with the NSFR intended outcomes. One area of difficulty arises when there is interdependency between the assets and liabilities. In this case, the asset cash flow may be dependent on the liability cash flow. Under these conditions, a variety of methodologies may be possible from excluding both the asset and the liability to only including one side. The Basel Committee does allow national supervisors to make the final ruling on what may be appropriate.

Another area of interest relates to the treatment of derivatives. Derivative assets have a weighting of 100% and require full funding, while derivative liabilities have a weight of 0% and do not contribute to the funding. Where a derivative position is a liability (either out of money or representing a loss) there is a funding requirement of 20% of the net derivative liability. The result is that the funding needed to support a significant derivative operation may increase exponentially.

The Basel Committee has described a common template that firms should use to publish their NSFR. The report will be made publically available, and will disclose the balance sheet categories and amounts used to calculate the ASF and RSF. The report will also disclose the unweighted amounts split by maturity band (no maturity; less than six months; between six months and one year; and over one year) as well as the weighted amounts by balance sheet category, enabling users to see how the NSFR was derived.

In addition, firms can give qualitative comments that will facilitate the understanding of the report. Comments about the drivers of the NSFR, or reasons for changes in the report over time, are encouraged.

Moving Forward with NSFR

As the new measure goes into effect, firms will be required to publish their NSFR on a quarterly basis along with their financial reporting. Where firms have typically reported on a semi-annual basis, each reporting period will now issue reports for two quarters.

The NSFR will potentially have a profound impact on the provisions of financial services. The repo funding agreements will see the provider of funds required to manage between 10% and 15% of the lending amount funded with stable funds. Equity in non-financial institutions has a RSF weighting of 50%, but unlike bonds there is no possibility of applying an interdependent asset liability exemption because the asset and liability do not have the same maturity. This potentially means that firms will need to stable fund up to half the value of their equity holdings. There may also be a marked impact on long-term lending, with the provisions of lending, such as project finance, shipping finance and aircraft finance, seeing new clauses that relieve the cost to the banking sector. These clauses may make the financing for the recipients less secure, as banks require more ways to match loans with available funding.

It is clear that firms have much to consider. In the near term, we can expect national regulators to issue their own guidelines on what will be required. Although 1 January 2018 is the stated deadline, we saw that the LCR was actually produced and published by firms way before the deadline to help enhance their market standing. I believe that the NSFR will be no different.

In the meantime, it is important that firms understand the requirements and review how they might extend the existing LCR reporting processes to cover this new requirement. Firms should also seek help from their providers and advisers, most of whom should already be preparing for the NSFR. As always, the best outcomes belong to those who are best prepared.


Related reading