The Net Stable Funding Ratio: Definition and impacts on the financial sector
In 2010, the Basel Committee on Banking Supervision released the third Basel accord as a response to the financial crisis that shook up the financial industry. This third accord focuses on liquidity risk management rules. Two new standards were released: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). This second ratio is designed to address liquidity mismatches by incentivizing banks to use stable source of funding for their long term assets and avoid any over-reliance on short-term funding as it had been observed.
However, since the publication of the Basel III document, there has been much debate surrounding the calibration of the NSFR. Indeed, this ratio could lead to market distortions and have a negative impact on the traditional role of banks.
Definition of the NSFR
The NSFR presents the proportion of long term assets funded by stable funding and is calculated as the amount of Available Stable Funding (ASF) divided by the amount of Required Stable Funding (RSF) over a one-year horizon. This ratio must equal or exceed 100% as shown in the equation below:
Stable funding is defined as "those types and amounts of equity and liability financing expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress".
The Available amount of Stable Funding includes bank's capital, preferred stock and liabilities with maturities greater than one year. Certain other types of liabilities with residual maturities shorter than 1 year that are not expected to be withdrawn during the stress period can also be included. Each component of the ASF is assigned an ASF factor which represents the proportion of the component's value that will be included in the calculation of the ASF and therefore the proportion that is expected to stay in a bank during a stress period.
The amount of RSF is calculated as the weighted sum of the value of assets held and funded by the bank including off-balance sheet exposure where the weights are the RSF factors. The RSF factor represents the portion of an asset that could not be monetized (e.g. through sales or collateralization) during a liquidity stress scenario and which needs to be covered by stable source of funding.
The NSFR's goal is to ensure a more stable funding profile for banks according to the maturity profile of assets and other exposures they present. Indeed, retail bank's business model rest upon the transformation of short term and cheap borrowing (e.g. savings account, wholesale funding) into long term and more profitable investments (e.g. loans). Banks then generate profits through the interest margin gained from difference between the interests paid and the ones received. This model is based on the maturity mismatch between the assets (long term and high interest rate) and the liabilities (short term and low interest rate).
By forcing banks to match the maturities of assets and liabilities, the NSFR aims at minimizing the risks induced by this model. However, matching liability and asset maturity does not fit into the actual banks' model. This is why, under the current calibration of the ratio, the NSFR may have unintended effects.
Indeed, the stable funding needed is more expensive and will drive down the profitability of their lending activities. Potential impacts on banks and the financial industry can be foreseen:
- Decrease in loans: with the net interest margin decreasing, banks could reduce their lending activities and focus other more profitable activities (financial markets, advisory, etc.). Banks will also increase the interest rates on their loans in order to maintain its profitability. This would, in turn, decrease the demand for loans and impact the GDP.
- Financial disintermediation: when banks reduce their lending activity, the demand for loans is likely to shift to other financial players. Corporates will probably rely more on the financial markets. Other channels could be used as shadow banking or securitization.
- Recapitalization: many banks need to find more stable source of funding to meet the NSFR standards. New issues of bonds and deposits hunt are to be expected.
- Concentration in some asset classes: banks could be tempted to sell assets that require more stable funding and invest more in those requiring less stable funding. For instance, mortgage loans require less stable funding than corporate loans; this could lead to a decrease in corporate loan and an increase in mortgage loans.
Pressure on stable funding
The Basel Committee expects banks to meet the NSFR standard by 2018. According to its last report banks still need to raise a significant amount of stable source of funding.
At the end of 2012, Group 1 banks showed an average NSFR of 100% and Group 2 banks had an average NSFR of 99%. Nevertheless, many banks still need to find additional sources of stable funding as only 53% of them meet or exceed the 100% minimum NSFR requirement. The aggregate NSFR shortfall at a minimum requirement of 100% was €2.0 trillion.
The result of the Basel Committee report shows that banks still need large amount of stable funding to meet the NSFR ratio. Indeed, while adapting to comply with the LCR ratio, banks typically left the compliance to the NSFR ratio in the second phase of their Basel III adaptation.
Even though the Basel Committee is currently reviewing the NSFR to avoid unintended consequences, banks will progressively start they work to comply with this second ratio. This large compliancy work will induce a pressure on the stable funding market. If €2.0 trillion are demanded in a too short period of time, the market might witness large and dramatic unintended consequences.