To cope with forthcoming regulatory requirements for long-term stable funding, banks should be working now on measurements, funding plans and business strategy.
Bank liquidity has been a top regulatory concern following the financial crisis, and now the focus has turned from short-term liquidity to a longer funding horizon of one year and beyond. To further safeguard liquidity solvency in all market conditions, banks will be required to maintain minimum specified levels of long-term stable funding.
The new standards are embodied in the net stable funding ratio (NSFR), targeted for implementation in January 2018. They follow the implementation of the liquidity coverage ratio (LCR), a plank of Basel III, which requires banks to maintain standby levels of reliable funding, in the form of high quality liquid assets (HQLA), sufficient to weather any contingency within 30 days.
NSFR will apply to the very largest Canadian and U.S. banks, including U.S. institutions with at least $250 billion of assets. A less stringent version will apply to mid-tier U.S. banks with assets of $50 billion to $250 billion. Many bankers have called NSFR a game-changer, given the wide-ranging impact on bank management. That will likely prove to be an understatement.
Unlike LCR, which is a short-term 30-day metric, NSFR compliance will broadly affect long-term funding requirements and provoke structural changes in the business and the balance sheet. To cope with the transition, executive teams must be disciplined, anticipatory and proactive in assessing and solving compliance-related shortfalls.
In addition to requiring considerable lead time, NSFR-related actions could well affect compliance with other regulatory requirements and constraints, such as capital and leverage. New metrics and forecasting tools will be needed. Banks not only must be able to reliably measure current-period NSFR, but also to model the forward NSFR position for individual business lines and the institution overall.
This rule introduces asymmetries in funding and collateral usage that will be difficult to manage and likely impact profitability. For example, NSFR requires expensive long-term funding for many high-value banking activities involving short-term investments and extensions of credit (Figure 1: Liquidity Strengths and Requirements under NSFR). Regarding collateral, top-quality liquid assets used as collateral in certain repo transactions will see their required stable funding increase from 5% when unencumbered to 50% during the life of the repo transaction.
The NSFR ratio calculation also introduces “cliff effects” — abrupt transitions that will be difficult to manage — when term liabilities hit the 12-month and six-month marks in their remaining term to maturity.
Consider, for example, a long-term wholesale funding issuance that initially receives 100% ASF credit. When its remaining term to maturity rolls down below the 12-month threshold, it will only receive a 50% credit. In a few instances ASF credit falls to zero at the six-month mark. For large issuances, these cliffs could provoke significant unfavorable swings in the NSFR ratio.
In the current climate of super-low rates and ample market liquidity, NSFR compliance could perhaps be viewed as hugely inconvenient but ultimately manageable. All bets are off in a future normalized market, however, when growth and regulatory pressures will surely place banks in a costly battle for core deposits. And while NSFR is intended to shield banks in the event of a future liquidity crisis, it could make a bad situation worse during an actual outbreak of market turmoil.
Among the largest U.S. and Canadian banks that will be fully affected by NSFR, we expect most to encounter constraints on balance sheet management because of this regulation. The NSFR-adjusted operating flexibility and standalone profitability of several business lines will be crimped — most notably capital markets and commercial banking — raising thorny questions about maximizing shareholder value through cross-subsidization from the deposit-rich retail side of the house.
To prepare for a likely difficult transition, there are three priorities that senior management should be working on now:
- Measurement. Enhanced data, methodologies and systems will be needed to optimize NSFR compliance by taking advantage of the most favourable treatments available. Also, given the long-term nature of NSFR and the required lead time to address shortfalls, it is critical that banks have the capability to robustly model forward NSFR positions, along with monitoring current status.
- Funding plan. The very core of asset-liability management will be touched by NSFR. Treasury must reconstitute the target funding profile for the bank, looking ahead three to five years in order to provide steady navigation and uphold shareholder returns.
- Business strategies and governance. A framework will be needed to balance the various NSFR considerations at the business line level. For accurate decision-making, advanced funds transfer pricing metrics will be needed to assess the impact of NSFR compliance on funding and profitability.
Time is running out for preparation. Banks that fail to execute on these three priorities risk being caught in reactive mode when NSFR rules take effect, constantly applying hasty patches to the balance sheet to meet compliance in changing conditions. Consequences include paying too much for funding and mis-valuing lending decisions in ways that are likely to be detrimental to returns.
Effects on Bank Businesses
NSFR will have a significant impact on bank balance sheets, profitability, and even the viability of certain businesses (Figure 2: Pervasive Impact of NSFR). From a bank management perspective, particular areas of concern include capital markets; lending; use of non-core funding; and balance sheet management and hedging.
Capital markets. Securities sales and trading businesses will be affected. Securities inventories held short-term for sale must be 50% backed by longer-term stable funding, increasing the cost of inventory financing. In one extreme example, securities normally held for only a few hours must be at least 50% backed by one-year funding.
Affected banks will have strong motivations to trim their securities inventories, denting fixed-income market liquidity. New issuance of corporate debt will become more costly and difficult, as banks will want to be compensated for the risk of having unsold inventory linger on their books with required costly long-term funding until it is sold off.
Lending. Lending businesses will see NSFR effects on loan profitability, primarily at the shorter end of the maturity spectrum, and on most unused commercial lines as well.
One of the fundamental benefits that banks provide to the economy is “maturity transformation” – packaging various and changing combinations of non-maturity deposits, time deposits, debt and other liabilities to provide credit facilities that meet a diverse range of borrower needs with different maturities and interest rates.
It is a balancing act that must be managed to avoid tilting to an over-reliance on transient liquidity. Unfortunately, NSFR overcompensates for potential funding imbalances by taking a stress scenario view that the bank must always fund with liabilities having terms that equal or exceed those of the assets being carried.
The real headache is at the short end of the maturity spectrum, where NSFR requires banks to maintain combinations of long-term deposits and other liabilities to support short-term credit facilities – creating negative maturity transformation. Most loans of 6-12 month maturities, for example, must be backed by some combination of funding that includes 50% over one-year term funding.
What would it take to meet this requirement in practice? Consider a 12-month loan for $100,000, which under NSFR needs to be backed at all times with $50,000 of funding that can be counted on for at least year.
In one scenario, the bank draws on core savings or checking deposits, which have no term to maturity. They can be held to satisfy RSF during the term of the 12-month loan and then immediately redeployed into other assets, which seems tidy, but there is a catch — opportunity cost. The bank is being forced to skip other liquidity options and tie up valuable core funding which potentially could have been used elsewhere to support higher-yielding longer-term assets.
In another scenario, the bank locks up term funding, possibly certificates of deposit. But to satisfy RSF, the CDs need to have at least one year remaining until maturity over the life of the loan, meaning they need to be booked with at least a two-year term at deal inception. Then when the loan rolls off, the bank would still need to hold a year’s worth of liquid assets (not requiring additional term funding) against the CD balances over their remaining term. Clearly an opportunity cost.
Another burden imposed by NSFR is that 5% of all undrawn committed credit and liquidity facilities must be backed by available stable funding. Based on recent figures for North American banks, it is estimated that this translates into a total funding requirement of approximately $125 billion for the largest U.S. banks and $90 billion for the largest Canadian banks.
Just as with our short-term loan example, banks will at a minimum incur an opportunity cost by encumbering core deposits that could have been used elsewhere. Plus they may need to use term funding with stretched maturities to assure an ongoing collective remaining life of at least one year. Either way, compliance will come at a cost — and that added cost must ultimately be passed along to borrowers, else lending returns will decline further.
Restrictions on non-core funding. Like the liquidity coverage ratio, the net stable funding ratio emphasizes core funding and penalizes the use of alternatives. Compared with non-maturity retail and small business deposits, 90% to 95% of which will be classified as available stable funding, corporate and most commercial deposits will have only a 50% ASF attribution. This further pressures large banks to pursue retail and small business deposits and shun non-operational deposits from corporate and financial entities.
Balance sheet management and hedging. Pre-crisis, bank treasuries would respond to interest rate risk and funding challenges as they arose, with limited perspectives on how future changes to the balance sheet would affect their positions. There were fewer ricochet effects inside the bank, as solving for one problem — say, interest rate risk — seldom exacerbated other situations.
Today, bank treasuries must contend with a host of complex and interrelated post-crisis regulations, of which NSFR may well be the capstone. The compliance waterfront will be absolutely covered — liquidity, capital usage, interest rate risk and portfolio funding characteristics — where solving a problem in one sphere creates headaches in others. When using derivatives to hedge transactions, for example, treasury groups often will encounter compliance cross-currents with liquidity buffers, term funding and capital leverage.
There are three major priorities that bank chief financial officers, treasurers, and business line leaders should be focusing on now in preparation for NSFR implementation (Figure 3: Establishing a Formal NSFR Program):
Get the measurements right. Banks have been working with draft rules for some time, so the NSFR measurement chase has started. But it is not nearly finished. As with other cascading and overlapping regulations, managing the bank within a complex compliance regime will require an ability to look across individual business silos to recognize and manage the composite picture. Today’s typical patchwork of silo-based data and metrics will not suffice.
To get the measurements right, management should:
- Contrast NSFR’s pro forma requirements with today’s reality to pinpoint data and methodology gaps and develop remediation plans. North American banks can draw a sharper picture when the rules are finalized, likely later this year.
- Get to work closing the gaps in methodology, data and systems, with a focus on taking advantage of the most favourable compliance treatments available. Some relief will come in the area of data assembly, as NSFR keys off of LCR definitions for many of its calculations. However, NSFR creates some new definitions and uses data differently than LCR. And NSFR intersections with other rules (e.g., capital leverage, LCR) make cross-silo integration a critical priority, not only with data but in financial management overall.
- Establish rigorous internal monitoring and external reporting. Long-term liquidity strength now matches capital strength in importance, not only for regulators and shareholders, but in the court of public perception as well. Robust external reporting will be essential in demonstrating compliance and liquidity strength. From an internal monitoring perspective, banks should revisit their risk appetite and limits framework, incorporating metrics that allow them to more proactively manage the term structure of their balance sheet — particularly given cliff effects in NSFR calculations — such as incorporating wholesale funding maturity concentration limits.
- Develop robust modeling of the forward NSFR position over a reasonably long planning horizon — ideally three to five years. This requires treasury to have a disciplined process for managing the funding plan, and more importantly, requires finance to collaborate with the business lines to develop a reliable forecast of the evolution of the balance sheet over the planning horizon.
Establish new target funding profile and plan. Based on global standards, starting in January 2018 each marginal asset will have funding rules attached to it. Banks will need to completely rethink their funding strategies and plans to meet NSFR requirements. Further complicating implementation is the interaction between NSFR and other regulatory rules on liquidity, capital, interest rate risk and total loss-absorbing capacity (TLAC).
Treasury management approaches will need to change, especially given the challenge of balancing complex regulatory constraints with management and shareholder objectives. To get on top of the situation, progressive teams will:
- Establish an optimal future target funding profile for the bank, balancing multiple (and sometimes conflicting) regulatory constraints, the bank’s risk appetite, and growth and profitability objectives;
- Develop a funding plan to move toward the optimal profile;
- Evaluate how each product / business line is currently being funded and assess changes required for NSFR;
- Incorporate NSFR and the new funding profile into FTP to refine business evaluations and decisions;
- Model forward results to assess binding constraints; and
- Optimize the funding plan within regulatory limits, risk appetite and bank objectives.
Integrate NSFR into business strategies and management processes of the bank. NSFR will create winners and losers at the business line level. Some units and types of activities may well become unprofitable on a standalone, fully-costed basis. Others will see their values maintained, or possibly even enhanced. To evaluate the strategic implications bankers should:
- Assess the impacts on each banking segment. Executive management will face dilemmas on cross-subsidization, as overall corporate returns may benefit if NSFR resources are shunted to one business line when in excess at another. For example, will (and should) retail deposit gathering subsidize corporate and capital markets businesses to benefit shareholders? To manage these trade-offs, overall bank performance metrics must be integrated with business line metrics, using advanced funds transfer pricing that will provide both business line and shareholder perspectives.
- Model forward results to assess binding constraints. Bank treasuries will need to think forward over a three- to four-year horizon to establish funding strategies that are balanced within regulatory constraints, and that optimize market opportunities and balance sheet resources.
- Develop strategic options that reflect business line and corporate impacts. A shareholder perspective may imply different strategies from those set at the business line level. Questions/actions will range from the tactical to the strategic, from repricing and product redesign; to business line restructuring; to cross-subsidization; and even to potential business line exits.
Complexities and Consequences
Executive management is just now developing an appreciation for the many aspects of banking that NSFR rules will affect. But given the complexities and potential performance consequences, there is no time to waste — new arrangements will need to be established and field-tested well before January 2018.
For large banks, treasury will have much more complex funding strategies to design and execute. Lending businesses will need to be revised to align strategies with required funding structures. Deposit businesses will have to understand the real value of deposits, given how competitively certain deposits will be fought for. And sales and trading businesses will have to be rethought to support higher inventory funding costs.
Many other banks outside of the top tier will be affected by a less rigorous imposition of NSFR. Even at these mid-tier banks, treasury will need to demonstrate a level of sophistication needed to manage more complex balance sheet strategies. Deposit-gathering businesses will need to develop tools to understand how to prudently use the likely influx of large wholesale deposits that larger banks may wind up releasing.
Yes, game changer seems right.
Steve Turner and Adel Mamhikoff are Managing Directors at Novantas, respectively in the New York and Toronto offices. They can be reached at email@example.com and firstname.lastname@example.org.