NSFR implementation uncertain after Basel III compromise on LCR phase-in

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The implementation of the Net Stable Funding Ratio (NSFR), a significant part of the Basel III bank liquidity regime, is likely to be delayed and could even be dropped, credit analysts and banking industry sources told dealReporter.

The NSFR aims to ensure banks are able to survive an extended closure of wholesale funding markets. It 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. The observation period for considering possible changes to the formulation announced in 2010, began last year and implementation is scheduled for 2018.

But two credit analysts and two banking industry sources said that a compromise agreement with The Basel Committee on Banking Supervision on the Liquidity Coverage Ratio (LCR) announced on 6 January has altered the landscape into which the NSFR rule were to be implemented.

Most significant among the announced changes to the LCR was to allow banks a wider range of assets, including equities and high quality residential mortgage backed securities, to count as easy-to-sell assets in the calculation of their funding requirements for surviving a 30-day liquidity crisis. Prior to the compromise, banks were to be restricted to holding cash and easy-to-sell assets such as government securities to meet the minimum standard.

The compromise also gives banks more flexible implementation terms and a longer phase-in period for the LCR. Banks are now only required to meet a minimum funding requirement of 60% in 2015, with this rising in equal annual steps of 10 percentage points to reach 100% on 1 January 2019.

The analyst and industry sources agreed that the changes to the LCR not only increase the likelihood of a delay in the NSFR, they set the stage for a larger re-think of the controversial measure.

“There is a correlation” between the two measures and their implementation, said one of the credit analysts, because the NSFR is supposed to pick up where the LCR leaves off. He noted that at the very least, the extended phase-in period for the LCR gives banks more time to monetize their long-term capital.

But it also gives them reason to expect that lobbying for more flexible terms on the NSFR would be similarly effective, especially as memories of the 2007 financial crisis recede.

For its part, the Basel Committee says it remains committed to the current implementation schedule for the NSFR and to the principle that requiring banks to hold high quality liquid assets for up to a year is necessary to prevent a future systemic collapse.

A person familiar with the Basel Committee’s plans also insisted that the implementation of the LCR and NSFR are not linked, but that the committee has prioritised its work on the LCR because it was due to be implemented earlier.

NSFR is in many ways more intrusive than LCR because it examines banks’ business models and practices. This requires banks to better match their assets and liabilities to prevent them from running out of funding if an extended crisis restricts their access to funding markets for up to a year. Such prolonged crisis conditions were responsible for the collapse of Northern Rock in 2007 and to a large extent Lehman Brothers the following year.

But two banking industry sources said they consider the current draft of the NSFR fundamentally flawed for several reasons. One of these sources said the NSFR as it is drafted really doesn’t work, in part because its “one-size-fits-all” approach makes otherwise stable funding facilities such as repurchase agreements (repos) unviable. At the same time, he said, the new standard creates “perverse incentives” that would cause banks to load up on potentially riskier assets simply because they match liabilities and allow the bank to meet the minimum standard.

One example of this is that a bank holding blue chip equities would be required to hold more stable funding (50%) than it would for a nine-month loan to a hedge fund, which can be held at a 0% weighting. Similarly, he said marketable securities held for less than a year are risk weighted at 5% under NSFR, while a retail mortgage loan somehow falls into the “all other assets” category, thereby requiring a 100% risk weighting.

Both industry sources said that while they welcome the compromise on the LCR and the longer implementation time frame, they feel the kind of issues that the NSFR tries to manage are more effectively addressed through the Basel III framework’s existing Pillar 2 requirements. These requirements include regular reporting of liquidity risks by the banks along with closer monitoring of cash flow forecasts and stress testing by the supervisor.

The second industry source said that regulators globally are already monitoring bank liquidity “much more closely than previously,” by looking at their models and monitoring the maturity of assets they hold, as well as by stress testing cash flows. He expects Pillar 2 reporting and national supervision to become the cornerstone of bank liquidity monitoring under Basel III.

This source cited a recent example of intensifying regulatory commitment to maintaining adequate liquidity in a recent note sent by the UK’s FSA to bank fund managers. He said that in the letter, the FSA asked fund managers to avoid putting retail clients into term deposits so as to “make sure deposits are on call,” as well as to protect depositors from losses in the event of a crisis.

The second industry source said he now expects that NSFR “will fade into the background over the next few years” as further lobbying by banks convinces regulators that implementation is both unnecessary and counter-productive. FSA declined to comment.

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