On the 7th of April, Risk Magazine published a piece by Lukas Becker entitled “Repo Desks Up In Arms About NSFR.” The article explains that Basel Committee on Banking Supervision’s (BCBS) Consultative Document on Basel III Net Stable Funding Ratio contains a little noticed requirement that could potentially have a dramatic impact on repo trading. Apparently, the requirement affecting repo initially went unnoticed and the industry is now scrambling to make its case to the BCBS before the consultative period ends on April 11.
The NSFR is designed to complement the Liquidity Coverage Ratio. The LCR goes into effect in 2015 and the NSFR in 2018. Most market participants are more familiar with the LCR. The LCR requires that banks hold sufficient highly liquid assets-cash or government securities to ensure that they can withstand a 30 day loss of funding. The theory being that these assets can be readily converted to cash during a time of market stress and will give a bank the ability to survive a market wide disruption. While there are exceptions for liquid securities, the effect has been a move to longer term funding of non-liquid collateral; e.g. corporate bonds, ABS and Private Label MBS.
On the other hand, the NSFR addresses the liability side of a bank’s balance sheet. It is a simple ratio of available stable funding (ASF) divided by required stable funding (RSF) sources. Banks will be required to maintain a ratio in excess of 1.00. Available stable funding is defined as customer deposits, long term wholesale funding and equity. On the asset side, different categories of assets are given different weightings; for instance, loans with a maturity beyond 1 year are given a 100% weighting, corporate loans with a maturity of less than 1 year are given a 50% weighting and government bonds are given a 20% weighting. The goal of this requirement is to ensure that banks match their funding to the maturity and liquidity structure of their assets.
The January consultative document proposes RSF weightings for securities financing trades (SFTs). Among these is a 50% factor for all loans with a maturity of less than 12 months to non-bank counterparties; including reverse repos. This would imply that all reverse repos with non-banks regardless of their maturity would require stable funding against 50% of their value. As an example, an overnight reverse repo for 100,000,000 US treasury notes between a bank and an asset manager would require $50,000,000 of long term funding. This potentially impacts SFTs with hedge funds, asset managers and insurance companies. The Risk Magazine piece goes to lengths to quantify the cost of this required funding. They estimate that in the current environment the cost of a treasury reverse repo could spike from 7 to 67 basis points to compensate for this new requirement. This would be consistent with one year funding in the neighborhood of 1.20%.
ICMA has published on this requirement a couple of times recently (“Collateral is the New Cash: The Systematic Risks of Inhibiting Collateral Fluidity” and “ICMA Quarterly Report Second Quarter 2014“.) In it they point out that this proposed ratio was not included in the 2010 original framework for the NSFR. They also carry the potential impact further to include broker-dealers and question whether even CCPs would be exempt. Clearly, there is the potential for a significant market disruption if this proposal is left intact as it is been outlined. On its face, the requirement is illogical. As the ICMA piece points out, there is no distinction made for high quality liquid assets, or for trades which are entered into for the purpose of covering firm shorts. There is no consideration given for the maturity of the reverse, nor is there a distinction made between levered accounts and ‘real money’ accounts.
Given all of this we have to question why this potentially drastic piece of regulation would come up so late in the reform process. Keep in mind that almost simultaneously the Basel Committee agreed to allow the practice of repo netting to continue largely intact and that CCP trading is the backbone of many market reforms. While the Risk article questions whether it is possible that the requirement was inserted by design, we have to wonder if this is the case. Looked at in the cold light of day, this is a requirement that could cause the secured finance market to grind to a halt. It does not make sense to disrupt the entire repo market by all but excluding SFTs with anyone other than a bank.