NSFR - Regulator's attempt to put Banks on a healthy long-term diet

As the effects of the global pandemic slowly wane, regulators are enforcing the much-awaited NSFR regulation. While the American and Swiss banks are required to adhere to these norms with effect from the second half of 2021, the remaining regulators are pushing for compliance from the first half of 2022. The seemingly innocuous NSFR regulation would have a profound impact on the banking business model and the financial markets.?

Unlike the LCR regulation, the ramifications of the NSFR regulations are far-reaching. The first and foremost impact is that the already tenuous profitability of the banks will be under immense pressure as banks compete for the long-term and stable funding sources that give higher ASF.?In general, deposits and common equity contribute to the major portion of the liabilities be it in real terms or the ASF (Available Stable Funding) terms. For example, approximately 70% to 80% of the overall ASF originates from these two categories. Since the equity capital is much more expensive with the cost of equity in the range of 10% to 15%, banks resort to raising deposits from retail and wholesale customers to bolster the available stable funding. Earlier Banks can easily game the short-term liquidity measures like LCR through raising medium-term deposits or through the short-term secured funding sources like Repo. For example, many banks in India offer terms deposits with a maturity of 31 days or term deposits requiring a notice period of 31 days to take these deposits just outside the purview of the LCR metric and increase the ratio by reducing the cash outflows from the deposits. The new NSFR template gives 0% ASF weightage to the repo transactions in < 6-month bucket and 50% to the wholesale deposits compared to the 95% ASF available for the retail deposits.

Source: Typical Bank Balance sheet multiplied by RSF/ASF weights

Note: As per the NSFR design, derivatives appear either on the RSF or the ASF side/

Thus, the earlier strategies wouldn’t work and banks have to move gradually away from relying on the volatile bulk corporate deposits to the stable retail deposits to garner higher ASF. However, sourcing of granular retail deposits tends to be expensive compared to bulk deposits as banks incur higher costs related to onboarding, interest expenses, and service-related costs. The NIM margins would be coming down marginally in the coming quarters, and we would be having statistical evidence for this soon. In addition, certain business units like the commodities business vertical would also be negatively affected because the NSFR regulation regards Gold as a non-liquid and a risky asset. As per NSFR, Gold assets, including the spot purchase for onward delivery in Forward transactions, attract 85% RSF, increasing the funding costs for the gold business. Thus, NSFR would put pressure on the bottom line for the banks, including some of its business units.

Source: Extract from the RBI FSR Report dated Jul 2021

As Banks compete for retail deposits, the duration of deposits would also be expected to increase because of the NSFR regulation. The average duration of deposits for most of the Indian Banks is between 3 years to 5 years whereas this metric for the foreign banks would be much shorter because of the lower interest rates and well-developed financial markets in developed countries. The increased duration of deposits would increase the duration of liabilities, affecting the ALM profile/duration gap of the bank. This could be a blessing in disguise as a shorter duration gap translates to lesser interest rate risk and reduced capital for the same, assuming the other factors remain the same. The NSFR metric would further increase the CASA growth,?both in terms of absolute value and as a proportion of the total liabilities.?

Source: Extract from the RBI FSR Report dated Jul 2021

Boards can set up far more transparent liquidity risk appetite statements with the advent of NSFR. Although a plethora of liquidity metrics are available for tracking the appetite, like LCR, Net Cumulative outflows, and Survival Horizon, the majority of these metrics are intractable and not easily understood outside the treasury.?Setting the appetite in terms of NSFR would help to align the incentives of the risk-taking business units with the bank’s overall liquidity risk appetite.

With the commencement of the NSFR regulation, banks across the world are gradually developing the required models to comply with the newest liquidity regulation. Since the NSFR reporting is in the nascent stages, a vast majority of the Indian banks still leverage excel models for reporting purposes. The Liquidity reporting tools like Moody’s Analytics, Oracle OFSA are already capable to provide automated systems for the NSFR reporting. Regardless of the system chosen, modeling of NSFR requires making multiple assumptions about the encumbrance process, derivative settlement, and the stability of deposits, increasing the model risk marginally. The most important aspect of the NSFR modeling is to model the encumbrance methodology. Banks need to first assess the on- and off-balance sheet assets that are eligible for encumbrance and then decide how they are used to cover the short positions. Often, the assets that are available for encumbrance are Long positions taken in bonds and equities, Reverse Repo assets, Collateral Swaps Received, and the derivative collaterals received from the counterparties. The complexity of the encumbrance would be further exacerbated by the Repo netting principle, which allows netting the Secured Financing transactions provided they are of the same quality and executed with the same counterparty and settle on the same day.

Finally, the business impact of the NSFR metric would be much more profound than the earlier liquidity metrics. Only time will tell if the NSFR would be as effective as the regulators expect it to be or it would be just another quarterly reporting metric that Banks submit to the regulator. For now, Basel and Regulators have given enough teeth to this metric to alter the bank’s balance sheet and affect markets in a positive direction.

Disclosure: The views expressed are strictly personal