What Basel’s Other Liquidity Ratio Means for Banks

by Joe Adler

OCT 7, 2014 3:09pm ET

WASHINGTON — When it comes to staving off liquidity crises, regulators have made more progress on preparing banks to survive their next heart attack than on preventing it from occurring in the first place. But that will soon change.

As U.S. banks work to comply with a global measure of their ability to withstand sudden liquidity shocks, the Basel Committee is poised to unveil the accompanying “net stable funding ratio”, a longer-term gauge designed to steady funding over a one-year period and discourage overreliance on short-term funding strategies that regulators say could lead to problems.

“It’s basically to wean you off of a weak funding model as opposed to getting you through an extreme short-term crisis,” said Darrell Duffie, a finance professor at Stanford University.

A final net stable funding ratio requirement comes after years of efforts to revise the ratio amid industry complaints that it will increase funding costs. Individual banks and trade groups had lauded the committee for making progress in its most recent NSFR proposal released in January, but said several concerns remain. (The committee has said it intends for the ratio to take effect in 2018.)

“It’s really hard over a one-year period to be able to make certain that you do have a sufficient amount of net stable funding, because things change very quickly, particularly over the course of a year,” said Michael Bleier, a partner at Reed Smith. “That means you have to go in with a pretty high buffer. … It’s going to put a damper on banks’ ability to take risks.”

Yet some experts say criticism has appeared to wane in a sign that banks may be willing to tolerate the Basel Committee’s final rule. “It looks like they’re calibrating it to a level that’s not going to be a big problem for” financial institutions, said Douglas Elliott, a fellow at the Brookings Institution.

Both the NSFR and the “liquidity coverage ratio” — which measures whether a bank can cover outflows over a short-term “stressed” period — were introduced as part of the 2010 comprehensive Basel III reforms. But the committee has significantly revised both since then. (The LCR was finalized last year, and U.S. regulators just finished implementing a more rigorous LCR version last month.)

On Sept. 25, the committee announced that a final net stable funding rule would be released within weeks. It will then go to each home country regulator to implement. “The NSFR complements the … [LCR] and ensures that a bank maintains a stable funding profile in relation to the composition of its assets and off-balance sheet activities,” said Basel Committee Chairman Stefan Ingves, governor of Sweden’s central bank, in a speech.

Whereas the liquidity coverage ratio ensures banks have enough liquid assets to sell in order to shore up funding for 30 days, the net stable funding ratio is a picture of funding stability over a one-year horizon and is designed to get maturities on assets to line up with those on the liabilities side. It requires a bank’s “available stable funding” to be equal to or greater than that which is needed to fund its balance sheet, which is defined as “required stable funding.”

In the numerator, each type of liquidity is assigned a weight based on its stability, which is determined by the committee. For example, regulatory capital and liabilities with maturities over a year are considered more stable than wholesale funding or shorter term deposits. Meanwhile, the denominator is the sum of the funding demands for various assets. Central bank reserves, for example, require zero funding. At the other extreme, a derivative would have to be fully funded at 100%.

To be sure, the imminent final NSFR framework from the Basel Committee is likely only the beginning of the rulemaking process for U.S. banks, as the international committee will hand the baton over to domestic regulators.

But as has been the case with other recent Basel standards, some say it is likely the U.S. will take a harder line in implementing the NSFR than the version agreed to internationally.

Even if the final Basel ratio is more to the industry’s liking, “the U.S. will reverse that somehow,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics. Comments to the committee on its January proposal expressed concerns that the factors given to short-term funding instruments painted all with too broad a brush.

“Not all short-term wholesale funding and financing transactions carry the same liquidity risk,” wrote several industry groups, including The Clearing House, in a joint letter. The same letter also pointed out that the NSFR seemed to assume a stressful environment in the liquidity markets. ”

A long-term ratio is much more appropriately analyzed on a business-as-usual or structural basis, in contrast to the acute stressed short-term conditions that the Liquidity Coverage Ratio … is aimed at,” the letter said. “It seems axiomatic that the NSFR should not be more conservative than the LCR, yet the draft is in effect more conservative in various ways.”

Some observers say that regardless of the final version of the rule, the NSFR will impose severe costs on banks’ ability to derive returns from “maturity transformation” — which basically means borrowing short while lending long.

“Short-term funding, as a rule, is less expensive than longer-dated funding,” said Donald Lamson, a partner at Shearman & Sterling LLP. He said the net stable funding rule is like “squeezing on a balloon.”

“If you’re reducing the returns you can make on your assets, I as a shareholder would pay less for your shares,” Lamson said. But Elliott said he has sensed less concern about banks’ ability to comply with the ratio. “A lot of the complaints have died down, which I’m assuming is because it’s turning out that not that many banks are really being pressured by it,” he said.

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