IMPACT ANALYSIS: U.S. bank regulators propose stable funding rule for banks; utility in question

May 27, 2016

U.S. financial regulators have taken a significant step in completing the last component of the original liquidity standards laid out by the Basel Committee with the proposed rule on the net stable funding ratio.

The U.S. proposal final rule is in line with the guidance of the Basel Committee.

However, a wide range of regulations have been implemented and banks have undergone structural changes since the drafting of the ratio, or NSFR, in late 2010 by the Basel Committee. The original goal of the NSFR standard — providing incentives for banks to migrate to asset and liability structures that are more stable and less pro-cyclical — may have already been realized. Therefore, it is not clear whether this metric keeps its initial conceptual basis as a meaningful indicator.

When the proposed rule gets finalized and takes effect, with a January 2018 target, it will apply to banks with more than $250 billion in assets and more than $10 billion in foreign exposure, affecting 15 banks. Another 20 banks between $50 billion and $250 billion in assets will have to abide by a similar rule, although with a less stringent form.

Liquidity metrics

The Basel Committee has devised two liquidity metrics.

One of these two metrics is the liquidity coverage ratio (LCR) for which the U.S. regulators finalized a rule in 2014. It evaluates how well a bank can withstand a liquidity shock scenario over a 30-day period based on the amount of its high-quality liquid assets.

The other one is the NSFR, which complements its “Basel cousin.” It is meant to limit a potentially unstable funding strategy by preventing banks from performing excessive amounts of maturity transformation by making too many illiquid long-term loans and investments funded by wholesale short-term money, as measured over a one-year time frame. In other words, systemically important banks in the U.S. will have to prove to regulators that they can keep liquid during that period.

The NSFR is designed to measure the ratio of a bank’s sources of stable funding (“available stable funding,” or the ASF, on the numerator) relative to its on- and off-balance sheet assets (“required stable funding,” or the RSF, on the denominator) through a granular factor-weight assignment system ranging from 0 percent to 100 percent in line with inherent liquidity characteristics of each type of asset or liability. The system is conceptually similar to Basel I and II asset risk-weighting systems in determining capital adequacy. Specifically, the factors are based on the funding tenor, funding type, and counterparty type.

Funding instruments perceived to be relatively unstable with less than a year of maturity such as certain short-term brokered deposits, non-deposit retail funding, and short-term securities financing transactions (repos, reverse repos, securities borrowing/lending, and securities margin lending) are, therefore, assigned low weight factors.

Most critically, the NSFR will cover the matched book securities financing transactions that go beyond the 30-day period of the LCR. This is in conformity with Federal Reserve’s original intention to require banks to hold a material amount of stable funding against short-term securities financing transaction loans. Indeed, Federal Reserve Governor Tarullo explained on several occasions how matched books can pose liquidity risks. “Running off assets may mean denying needed funding to clients with which the firm has a valuable relationship, and a firm with a large matched book will almost surely be creating liquidity squeezes for these other market actors,” he said.

The original rationale underlying the NSFR, then, was to force banks to change their liquidity profile through a combination of the following: (i) replace short-term with long-term funding; (ii) replace unsecured with secured funding; (iii) replace illiquid with liquid assets; (iv) shorten maturities of the loan book; and (v) decrease (illiquid) asset holdings that require stable funding.

Regulatory reforms

In the wake of the financial crisis, a slew of regulatory reforms have made it more difficult for banks to rely on volatile short-term funds, either directly or indirectly. Chief among these are the increased capital surcharge (G-SIB surcharge), long-term debt requirement, and possibly the relatively obscure annual Comprehensive Liquidity Assessment and Reviews (CLAR).

The G-SIB surcharge specifically replaces one of the typically used Basel criteria of substitutability with bank’s reliance on short-term wholesale funding through a two-method calculation — other Basel criteria of G-SIB size, interconnectedness, cross-jurisdictional activity, and complexity are kept — to dissuade banks from using such type of funding.

The long-term debt requirement, designed to ensure the continuation of critical operations of a G-SIB during resolution, is targeted at the maintenance of a certain amount of long-term debt that is easily convertible into equity, and indirectly discourages the use of short-term debt.

The CLAR

Another significant reform that has been instituted is the Comprehensive Liquidity Assessment and Review. It is essentially an annual horizontal review conducted by the Federal Reserve to provide a consistent, cross-firm evaluation of liquidity position, and liquidity-risk management. It allows the Fed regulators to establish a continuous communication channel with the compliance departments of systemically important banks to assess and contain liquidity risks and decide upon changes, where necessary, to their specific funding practices.

In assessing the adequacy of the banks’ liquidity positions, the regulators look at their internal evaluation and measurement of liquidity risk, their funding planning processes including contingent funding, and compare these with their independent evaluation of their liquidity profiles.

Essentially, the CLAR involves a range of supervisory liquidity analyses of funding concentrations, longer funding horizons, and reliance on short-term wholesale funding. It also assesses banks’ own internal stress tests, including their assumptions regarding liquidity needs for their prime brokerage services and derivatives trading under stress scenarios.

In contrast to its counterpart on capital tests, the Comprehensive Capital Adequacy Reviews (CCAR), which have partial public disclosures, supervisory stress scenarios and outcomes from CLAR are currently not transparent. Notwithstanding this aura of opacity, it is said that banks have enhanced their capability to monitor and track liquidity needs under normal and stressed conditions at both the consolidated and material entity level thanks to the implementation of CLAR.

Change in banks’ funding profile

Partly as a result of these regulatory reforms, and partly because of a ramp-up of their risk management practices, banks’ reliance on relatively short-term volatile types of funding has decreased since the last financial crisis.

Studies by industry groups, consulting firms, and regulatory agencies alike indicate that banks have reduced their reliance on short-term wholesale funding since the financial crisis. A Clearing House study found that U.S. commercial banks have cut the portion of their wholesale funding from the 2008 peak of 30 percent of total funding to about 18 percent in the second quarter of 2012. Further, commercial banks went from being significant net users of short-term funding prior to the crisis to being net suppliers in the years to follow –specifically, the volume of short-term liabilities minus short-term assets has fallen from 10 percent of total assets to -6 percent. A recent study , conducted by Oliver Wyman, confirms these results. It finds that the risk of runs “has been reduced due to an increase in more stable deposit funding, diminished reliance on short term wholesale funding, and the improved liquidity profile of banking assets.”

Although adopting a somewhat more cautious tone than the industry reports, the findings of the annual report by the Office of Financial Research — a regulatory arm of the Treasury entrusted with measuring and analyzing risks, collecting and standardizing financial data — are similar.

The report recognizes that “risks that short-term, wholesale funding could be vulnerable to the kind of runs and fire sales that marked the financial crisis continue to exist,” but ultimately concludes by stating that “regulatory reforms after the 2007-09 financial crisis forced banks to reduce their use of short-term wholesale funding. These changes, combined with changes in the behavior of market participants and improvement in companies’ risk management, dramatically reduced the size of these markets since the crisis.”

Other relatively unstable forms of funding such as commercial paper issuance and bank use of repurchase liabilities have also decreased, roughly by two-thirds and one-quarter, respectively, since the height of the financial crisis.

The usefulness of NSFR

Debate continues among industry participants on whether the NSFR has outlived its usefulness as a regulatory tool in light of the regulations mentioned above, and the recent changes in liquidity and funding profile of banks. The Clearing House, a trade group representing large U.S. banks, has questioned the necessity of the rule, arguing that the funding risk is already addressed by multiple new regulatory measures.

“The issue of reliance on short-term funding is not new. We had it back in the 80’s with the failure of the Continental,” said Oliver Ireland, a partner with Morrison Foerster, reflecting on the regulatory actions back then and since the last crisis. “While they are not necessarily redundant, a lot of these rules such as G-SIB surcharge, the supplementary leverage ratio, and the liquidity stress tests are aimed at reducing this type of reliance through some discretionary standards. The LCR and NSFR are simply more scientific tools in measuring the same concept.”

Compounding this skepticism toward the NSFR is a disagreement over the right level of maturity transformation (one-year being the cut-off for most instruments), the conceptual basis for the available and required funding factors, and the calibration assumptions. Neither the Basel Committee, nor the U.S. regulators provide a clear answer or a precise calculation yielding these parameters.

There are some advocates of the NSFR, however, who see it as a helpful complement to other regulatory tools. “I don’t think the LCR and NSFR overlap with the CLAR,” said Shyam Venkat, principal in Financial Services Advisory at PwC. “While the liquidity ratios are supervisory prescribed metrics applied to all banks, CLAR is a less codified, but more tailor-made evaluation of the liquidity governance that takes into account specific characteristics of each bank.”

Operational challenges

If there is disagreement on the usefulness of the NSFR, there is also a clear consensus on where challenges lie regarding its implementation.

The banks are not expected to have difficulty meeting the quantitative requirements of the rule. Bank regulators estimate that nearly all of the banks would be in compliance with the proposed rule if it were to go into effect immediately, with a current shortfall of only $39 billion — equivalent to 0.5 percent of the aggregate required stable funding, or RSF.

Instead, “the rule — if passed in its proposed format — will provide operational challenges for the banks,” said Matt Dunn, a director at Deloitte over a phone interview.

NSFR figures will have to be reported on a quarterly basis. If a bank fails to maintain its ratio of 1 –that is, its available funding falls below its required funding– it would be required to notify its regulator within two weeks of the reason, present a remediation plan for addressing the shortfall, and substantiate the plan with subsequent progress reports.

The disclosure requirement on NSFR will come in addition to the already burdensome liquidity reporting requirements banks have to go through on a daily basis, where they have to cover every type of funding classifications by product, outstanding balance and purpose, segmented by maturity date.

Banks subject to the rule will have to start work in earnest in calculating their exposures to counterparties taking into account the ASF and RSF factors, determine whether their current liquidity and funding profiles present any issues under the rule, assess shortfalls (if any), and develop plans to address them before the rule’s projected implementation date of 2018.

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on May. 19. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

(Bora Yagiz, FRM is a New York-based Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence, specializing in risk. He is a certified Financial Risk Manager. Mr. Yagiz has held positions as a bank examiner for the Federal Reserve Bank of New York, as senior consultant with Ernst & Young and vice president at Morgan Stanley. Follow Bora on Twitter@Bora_Yagiz. Email Bora at bora.yagiz@thomsonreuters.com)

 

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