Net Stable Funding Ratio is a liquidity standard that requires banks to have sufficient stable funds to cover the duration of their long-term assets. For funding and assets, long-term is generally defined as more than one year, with the lower requirement applying to anything between six months and one year to avoid a cliff edge effect. Banks must maintain a ratio of 100% to meet these requirements.
Introduced as part of the post-crisis banking reform known as Basel III, the ratio ensures banks don’t carry out excessive maturity transformations, namely the practice of using short-term funding to meet long-term obligations. The degree of risk depends in part on the nature of the collateral and the counterparty involved. If the collateral is a highly rated government bond, and the counterparty is a large capital institution, then the risk is minimal. It’s another story, of course, if a bank accepts lower-rated securities from a high-leverage hedge fund.
The Basel III capital framework uses this kind of risk capture approach, with the leverage ratio acting as a buffer for risk-based capital requirements. This may not be sufficient, off-balance sheet activity avoids the former, and it may also not appear in risk-weighted assets. “One of the reasons repos can be dangerous is that, if over-guaranteed trades are even small, banks can list zero risk-weighted assets,” said Benedict Roth, a former supervisor at the Bank of England.
Basel III architects lived with this problem. The liquidity coverage ratio and net stable funding ratio (NSFR) were introduced as additional safeguards, to ensure banks do not run into excessive liquidity risk. The latter requires companies to maintain a stable minimum level of long-term funding that is appropriate for their assets. The treatment of repo loans and securities in the NSFR is asymmetrical – funding provided to financial firms requires stable funding, but funding raised from other financial firms does not count as available stable funding – to prevent banks from relying on other leveraged entities for funding.
The ratio also differentiates based on the quality of the collateral. High quality government bonds require 5% stable funding, while corporate and equity bonds have 50% stable funding requirements. To the extent that Nomura’s off-balance sheet activity poses a liquidity risk, due to the collateral and counterparties involved, this should appear in the NSFR. But national regulators have been slow to implement this last part of the Basel III framework.
Net Stable Funding Ratio (NSFR) or Net Stable Funding Ratio is a banking term that states the comparison value between Available Stable Funding (ASF) or Available Stable Funding and Required Stable Funding (RSF). Required Stable Funding must be greater than 100%, which is if formulated is:
NSFR = ASF/RSF > 100%
Available Stable Funding (ASF)
ASF is the sum of the stable equity and liability sectors within 1 year which is used to fund banking activities. In terms of equity value, it is estimated that the maturity value of less than 1 year originating from deposits from individual customers as well as micro businesses and small businesses must be greater than corporate customers. This includes core bank capital (Tier 1) and supplementary capital (Tier 2).
For the value of the liability, it is calculated that all loans and liabilities, whether using collateral or not, with a period of 1 year are also included in this case are deposits and securities issued.
Required Stable Funding (RSF)
RSF is the sum of assets and administrative account transactions that are funded by stable funding. Included in the RSF are purchase orders or sales orders that have been successfully executed, financial assets, foreign currencies and commodities.
History of Net Stable Funding Ratio (NSFR)
In 2008 there was a worldwide financial crisis that started in the United States, one of which was caused by a liquidity crisis in banks. This is actually very surprising because when viewed from the side of capital, the actual capital owned is more than sufficient category. However, it turns out that having large capital alone is not enough to survive in the financial system if banks are not careful in managing their liquidity.
One of the banking activities is intermediation, which is tasked with receiving funding and then redistributing it in the form of credit or placed in certain assets with different time periods. The crisis in 2008 could occur because previously there were no official regulations binding banks to implement liquidity risk management which ultimately to get the maximum profit, banks depended heavily on short-term funding from corporations.
Even though the number of customers in the corporate category is very small, the amount that is entered is very large so that the banking balance can rise very quickly, but the problem is that money is very unstable because it creates an imbalance between short-term and long-term funding which eventually has a systemic impact.
After the crisis occurred, then financial institutions realized that liquidity risk management was necessary and how the balance sheet of the bank must be balanced between money obtained from corporate customers with a short-term orientation and individual customers with a long-term orientation. Still in 2008 a few months after the crisis, The Basel Committee on Banking Supervision (BCBS), which is a collection of world bankers, published a banking guide entitled Principles for Sound Liquidity Risk Management and Supervision or better known as Basel III Reform.
Stable financing refers to customer deposits and long-term financing, short-term financing is excluded. The use of this ratio in practice will lead to an increase in the stability of the banking system, its ability to withstand stress factors in the event of a possible crisis, including a liquidity crisis. The introduction of the NFSR is fully in line with the implementation of the Basel III recommendations, based on lessons learned from the Great Recession that occurred in 2007 to 2008 that affected all global financial markets (same as LCR).
In general, banks that have not complied with the NSFR should make structural adjustments to their balance sheets by increasing stable funding and lowering average loan terms. This will limit the ability of banks to provide loans other than short term and will have a severe impact on the category of assets that play an important role in increasing average maturities. An IMF survey noted that disparities between countries can be significant. In general, the application of these ratios tends to lead to a decrease in large-scale financing (especially short-term), an increase in deposits, a decrease in the volume of long-term loans and an increase in liquid assets.
For many financial institutions, liquidity problems may not only be related to capital. Because supply constraints play a key role (availability of deposits, medium-term financing, and high quality liquid assets). To meet the new quantitative standards, banks will have to enter more intense competition for deposits, work more actively to refinance medium-term funds at favorable interest rates, and potentially increase their ability to transact with liquid assets.
Currently, banking financial institutions need to assess the impact of the new liquidity management regime on the balance sheet. This is necessary to identify potential conflicts between the current funding structure and the requirements of the new regulatory regime. Taking into account the new quantitative requirements, financial institutions also need to pay attention to the creation of a reliable liquidity management system: the regulator has clearly indicated that this system should be considered taking into account the implementation of new quantitative standards and monitoring tools.