eighteen53 Blog

NSFR Update: Bad and Getting Worse

Posted 01/10/2018 by Bill Nelson

Late last year, the Basel Committee on Banking Supervision (BCBS) released a “technical amendment” to its Net Stable Funding Ratio (NSFR) liquidity standard.  While relatively minor, the adjustment has the effect of making a seriously flawed regulatory standard even more flawed.  Moreover, the change increases further the incentives provided by the Basel III regulatory reforms for banks to do business with central banks instead of with each other.

As we have written extensively before (see “Blog: Send the NSFR back to Basel” and the nine other TCH notes on the NSFR cited therein), it is no longer clear what, exactly, the NSFR is intended to do, but originally, it was intended to ensure that a bank is funded in a way that enables it to endure a year of liquidity pressure.  In short, assets that the bank would likely still be holding over the year must be funded with liabilities that won’t go away.  Subsequent revisions to the regulation have been inconsistent with that objective, and indeed, the objective has been dropped outright from the BCBS documents without replacement. 

The technical amendment, which deals with loans from banks to central banks with more than 6 month maturities, takes the NSFR further from its initial objective and provides a nice illustration of the steady corruption of the regulation.  As originally proposed in December 2010, loans to central banks with maturities of less than one year required no stable funding under the NSFR because the bank making the loan would have the funds back within the year.  Loans to central banks with maturities of more than one year required 65 percent stable funding, reflecting the fact that the money would be locked up more than a year albeit with an offset for the ultra-low risk of the asset.

In October 2014, the NSFR was revised extensively.  Among other changes, the required stable funding for loans to central banks with maturities between 6 months and 1 year was raised to 50 percent even though the funds would, in fact, be 100 percent available by year-end.

The December 2017 “technical” amendment lowers the required stable funding on loans to central banks with maturities of greater than 6 months to 5 percent when the loans are part of extraordinary central bank operations.  The standard defines “extraordinary central bank operations” as “non-standard, temporary operations conducted by the central bank in order to achieve its mandate in a period of market-wide financial stress and/or exceptional macroeconomic challenges.”  Note in particular that loans to the central bank that have maturities of more than one year would still require only 5 percent stable funding even though the funds will be locked up past, potentially long past, the NSFR one-year horizon. Thus, the change moves the NSFR even further from its original objective.

By contrast, when a bank lends overnight to a private counterparty in the form of a reverse repo secured by U.S. Treasury securities, one of the most liquid of all assets, it must fund that loan with 10 percent stable funding, and when it lends overnight in the federal funds market, it must have 15 percent stable funding.  Loans by banks to market entities that have maturities greater than one year generally require 100 percent stable funding.  Consequently, the change makes it more attractive for banks to lend money to the central bank than to private-sector counterparties. 

In 2015, a BIS working group on Regulatory Change and Monetary Policy found that the post crisis regulatory reforms already had the tendency to increase reliance on central banks for two reasons.  First, the regulatory changes will make it more difficult to forecast the demand for reserve balances and will reduce the forces of arbitrage across financial markets, requiring more frequent and broader-based monetary policy interventions by the central bank.  Indeed, these arguments are precisely the ones presented by the Federal Reserve for why it is inclined to adopt a large-balance sheet floor-based monetary policy implementation regime instead of returning to the small-imprint regime it used before the crisis.

Second, the report notes that in a number of instances the post-crisis regulations treat financial interactions with the central bank more favorably than interactions with private counterparties.  For example, the LCR standard assumes that loans from a central bank backed by illiquid collateral are perpetually rolled over while similar loans from private counter-parties are assumed to never be rolled over.  As another example, concentration limits on the exposures of large banks do not apply to exposures to central banks.  And in the NSFR, it was already the case that collateral provided to the central bank to secure an “extraordinary” loan from could be treated as unencumbered.  The current proposed technical amendment effectively provides similar treatment to loans made to the central bank.

 

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, and are not intended to be, and should not be construed as, legal advice of any kind.

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