What is the Net Stable Funding Ratio?
In the early liquidity stage of the financial crisis beginning in 2007, several banks – despite fulfilling existing capital criteria – faced problems because they could not handle their liquidity prudently. Following the collapse of several banks in 2007 and subsequent years, the Basel Committee on Banking Supervision (BCBS) adopted two liquidity requirements as part of the Basel III post-crisis reforms.
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Requirement and Criteria for the Net Stable Funding Ratio:
Under LCR the bank has to ensure that they maintain a sufficient amount of high-quality liquid assets (HQLA) to meet such short-term future crises. The motive to introduce NSFR is to reduce the funding risk over a long period, by requiring banks to fund their activities with sufficiently stable sources of funding, in order to mitigate the risk of future funding risk. NSFR standard was become a minimum stander for liquidity risk framework from 1 January 2018.
NSFR is defined as the ratio of Total Available Stable Funding (ASF) and Total Required Stable Funding (RSF) should be equal or exceed 100%. Thus the formula for NSFR can be made as follow:
Here, ASF is the proportion of banks’ capital and liquidity that remain with them for more than 1 year.
The various ASF factors which are associated under liability categories for the calculation of ASF:
- If the ASF factor range from 100% this means that the funding is fully stable and available for more than 1 year.
- If the ASF factor is 95% this means that the funding is stable and available for less than 1 year provided by retail and small business customers.
- If the ASF factor is 90% than the funding are less stable for less than one year
- If the ASF factor is 50% then the funding liability will be of less than one year by non-financial corporate customers.
- And if the ASF factor is 0 % then the funding from such a source is unreliable.
RSF is the weighted sum of the total value of assets held by the bank including the off-balance sheet exposure.
- RSF factor at 100% indicates that assets on the balance sheet have a residual maturity for more than 1 year.
- RSF factor at 0% indicates that the bank has residual maturity for less than six months including the entire claim from the central bank.
Banks must maintain the NSFR to at least100% if their assets are more than $250 billion.
Banks must maintain NSFR to at least 70% of their assets requirement is between $50 to $205 billion.
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Impact of Net Stable Funding Ratio:
- The cost of NSFR in its current form will have an impact on banks that traditionally rely on wholesale banking for funding. To maintain the NSFR banks have to reduce their lending activity and this may result in a reduction in profit. Hence to increase the profit, banks may increase the rate of interest on loans and this may result in decreasing the flow of funds in the market and will affect the economy.
- If the banks reduce their funding activity that most of the market players will lead to money from the capital and other institution and this may also result in a decrease in profit for the banking sector. Other channels could be used as shadow banking or securitization.
- To meet the NSFR standard, banks may issue more bonds and securities to meet their stable funding amount. It also has a major potential effect on the cost of doing business of Prime Brokers and, subsequently, of hedge funds.
Banks could be inclined to sell assets that need more stable funding and to invest more in those that require less stable funding.
The Basel Committee expects the banks to comply with the NSFR standard and according to its latest report, the banks also need to raise a substantial amount of stable funding. The Basel III Liquidity Structure includes a range of crucial steps that will improve the resistance of banks to short-term liquidity shocks, encourage a more structurally stable financial profile for them, and strengthen their incentives to properly identify and handle liquidity risks.
Author: Charmi Mehta
About the Author: Charmi Mehta is currently pursuing an MBA with a specialization in Finance from the Department of Business Administration, Bhavnagar. Charmi is very much interested to work with data and its analysis and she is also fascinated by the financial market.