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Send the NSFR back to Basel

Posted 08/28/2017 by Brett Waxman and Bill Nelson

One of the recommendations in the report the Treasury Department released in June was for the U.S. banking agencies to delay implementation of the net stable funding ratio (NSFR) requirement until it could be reviewed and recalibrated, noting that it would introduce potentially unnecessary liquidity requirements and duplicate other requirements.  We encourage the U.S. banking agencies to send the regulation back to Basel for a fundamental reconsideration. 

The NSFR was the last of the major post-crisis regulatory reforms released by the Basel Committee.  It is intended to ensure that banks have a robust funding profile and to complement the liquidity coverage ratio (LCR) requirement, which focuses on liquidity at a thirty-day time horizon. The NSFR was always the runt of the Basel III litter, and when the international standard was finalized by the Basel Committee on Banking Supervision on a rushed basis  in October 2014, the final round of changes to the regulation introduced serious flaws likely to have unintended consequences.  (The Clearing House has discussed problems with the NSFR in “The NSFR – A Few Questions,” “The NSFR, Neither Necessary nor Harmless,” “Financial Trade Associations Ask Bank Regulators to Reconsider NSFR,” “Liquidity Regulations, the Neutral Real Federal Funds Rate, and the Money Premium,” “Unintended Consequences of Tighter Liquidity Requirements,” “In NSFR Terms, the Dodgers Already Clinched the Series against the Nationals,” “The NSFR requirement and Giffen Goods,” “TCH Files Joint-Trades Supplemental Letter on NSFR,” and “Foundational Basel Committee Study Estimates the Costs of NSFR Exceeds its Benefits by Nearly $1 Trillion”). 

That’s quite a lot of discussion, come to think of it, but each week seems to present a new reason to conclude that the NSFR is unwise, whether because of its high cost or low benefits.

For example, the changes made to the NSFR illogically penalize banks for making very short term loans collateralized by government securities, one of the most liquid and safe investments banks can make.  That change can “affect the liquidity of securities,” “undermine market-making activities,” and “endanger the effectiveness of the LCR.”  Those quotes aren’t from our reports, rather they are from the statement by the European Commission explaining why it scaled back its proposed implementation of the NSFR from the Basel-agreed upon standard.  The final NSFR changes even penalize banks for holding government securities, in a manner that is “not consistent with the LCR” (again, the European Commission).

Nevertheless, the U.S. banking agencies proposed in the second quarter of 2016 a version of the NSFR in the United States that is even more stringent than the international standard.  One reason for the seeming insouciance of the U.S. banking agencies about problems with the regulation is likely that U.S. banks, for the most part, appear currently able to comply with the requirement with little strain.  But as we show in “Neither Necessary nor Harmless,” that situation is likely to change as the Federal Reserve normalizes the size of its balance sheet (a process likely to begin in a few months) and as interest rates normalize (a process that has already begun).  The normalization of the Fed’s balance sheet will shrink the level of bank deposits at the Fed, known as excess reserves, which require no stable funding under the NSFR.  As the level of market interest rates increase the normal spread of market rates over retail deposit rates will be reestablished.  As a result, retail deposits, which are bank liabilities that provide a lot of stable funding under the NSFR, will become a smaller share of bank funding.  Thus, U.S. banks will likely find it increasingly difficult to comply with the NSFR.  The foreseeable consequence will be that banks pull back from activities that require a lot of stable funding, such as making longer-term loans to small businesses and households.  That pressure to reduce such lending will come on top of the disincentives already established by the annual stress tests (see Covas (2017)).

Another reason why the U.S. banking agencies may be eager for the NSFR to be adopted could be that it includes provisions to make it costly for banks to hold large matched-repo books (repos and reverse repos that match and so offset each other).  The U.S. agencies made changes to the calculation of the GSIB capital surcharge that is charged to the largest U.S. banks in order to penalize matched repo books, but the NSFR is the only internationally agreed upon regulation that would put in place any penalty for non-U.S. banks.  If that is a reason, the U.S. banking agencies should take note that the European proposal for the NSFR reduces the penalty for matched books, while the Japanese have not yet proposed the NSFR for adoption, waiting to see what Europe and the United States do.  There would appear to be a good chance that the U.S. banking agencies, in their desire to create a level playing field, end up tilting it even further by having two penalties on matched repo books for U.S. banks while the rest of the world has essentially none.

Meanwhile, the U.S. banking agencies have put in place other requirements that make the NSFR redundant, at least in the United States.  Specifically, banks in the United States with at least $50B in total consolidated assets are required to report to their supervisors the results of liquidity stress tests that are conducted at least monthly at the overnight, 30-day, 90-day, and one-year horizon.

Given the NSFR’s flaws and redundancy, and the reluctance of the rest of the world to adopt it, the best course of action would appear to be for the Basel Committee to start from scratch and take the time needed to develop a longer-term liquidity metric that is coherently designed and could be universally adopted.  But if they and the U.S. agencies insist on going forward, at a minimum, they should do the following:

  1. Release in full the analytical underpinnings and empirical support the U.S. banking agencies relied upon in proposing the rule and reopen the public comment period in order to allow meaningful opportunity to evaluate and comment upon these critical foundations for any regulatory framework.  (One might even argue that this step is legally required.) 

  2. Ensure that the regulation is grounded on and calibrated to a clearly defined objective, with the calibration based on historical evidence or clear policy reasons for a deviation from the evidence.

  3. Modify the regulation to be consistent with the LCR.  For example, since the LCR assumes banks can sell all their government securities in 30 days, the NSFR shouldn’t assume (as it does now), the banks can’t sell all their government securities in one year.

  4. Carefully consider, in the context of both the existing impact of extant U.S. capital and liquidity regulation and the unique nature of the U.S. financial system, whether changes are required to avoid unnecessary harm to the U.S. banking sector and the broader economy.

Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership.



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