US Bank Regulators Finalize Net Stable Funding Ratio Rule

Despite attracting recent controversy from some—who have noted that if it had been in effect earlier in 2020, initial financial stress from the COVID-19 pandemic would have been worse—the long-anticipated net stable funding ratio (NSFR) rule has been finalized by the Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and Board of Governors of the Federal Reserve System (FRB) (collectively, the “Agencies”). The NSFR was developed after the 2008 financial crisis revealed that an over-reliance on short-term, less-stable funding sources could make large banking organizations more susceptible to funding changes. The NSFR rule is a quantitative liquidity standard that was originally adopted in October 2014 by the Basel Committee on Banking Supervision (BCBS) as part of the Basel III regime and was first proposed by the Agencies in 2016.¹ The proposed and final NSFR rules differ from the standard developed by the BCBS based on US-market specific factors.

The full NSFR rule will apply to nine of the largest US banking organizations and to their consolidated subsidiaries that are depository institutions with $10 billion or more in total consolidated assets. A modified version of the NSFR rule will apply to 11 other depository institution holding companies with assets of at least $100 billion, including certain intermediate holding companies formed by foreign banking organizations (FBOs) under FRB’s Regulation YY, as well as certain of their consolidated subsidiaries that are depository institutions with $10 billion or more in total consolidated assets. The NSFR rule will not apply to FBOs or US branches and agencies of FBOs.²

The NSFR rule generally is similar to the proposal from May 2016, but, most notably, the scope of the NSFR rule has been recalibrated to be consistent with the Agencies’ 2019 tailoring rule.³ Additionally, FRB indicated that it intends to propose changes to the FR 2052a to incorporate the reporting requirements under the NSFR rule. The NSFR rule will take effect on July 1, 2021.

Background

The Agencies proposed the NSFR rule in 2016 to complement other post-financial crisis liquidity-related reforms, including:

• The liquidity coverage ratio (LCR) rule, which requires certain large banking organizations to hold a minimum amount of high-quality liquid assets (HQLA) that can be readily converted into cash to meet net cash outflows over a stressed 30-calendar-day period.
• Liquidity risk management and stress testing requirements under FRB’s Regulation YY “enhanced prudential standards.”
• The wholesale funding component under FRB’s risk-based capital surcharge for global systemically important banking organizations (G-SIBs) in the United States.
• FRB’s long-term debt and total loss absorbing capacity (TLAC) requirement that requires US G-SIBs and the US operations of certain foreign G-SIBs to have sufficient amounts of equity and eligible long-term debt to improve their ability to absorb significant losses and withstand financial stress.

Unlike these other reforms, the NSFR rule specifically addresses long-term liquidity risk by requiring covered companies (defined below) to maintain a minimum level of stable funding over a one-year period. The NSFR rule is complementary to the LCR rule and the other initiatives highlighted above.

Definition of Covered Companies

The proposed NSFR would have applied to: (1) bank holding companies, savings and loan holding companies without significant commercial or insurance operations, and depository institutions that, in each case, had $250 billion or more in total consolidated assets or $10 billion or more in on-balance sheet foreign exposure, and (2) depository institutions with $10 billion or more in total consolidated assets that were consolidated subsidiaries of such bank holding companies and savings and loan holding companies.

FRB also proposed a modified version of the NSFR rule that would have applied to bank holding companies and savings and loan holding companies without significant insurance or commercial operations that, in each case, had $50 billion or more, but less than $250 billion, in total consolidated assets and less than $10 billion in total on-balance sheet foreign exposure.⁴

In 2019, the Agencies tailored the application of the LCR rule, regulatory capital rules, and enhanced prudential standards by categorizing domestic and foreign financial institutions with $100 billion or more in total assets into four different categories based on several factors, including asset size, cross-jurisdictional activity, reliance on short-term wholesale funding, nonbank assets, and off-balance sheet exposure. Specifically, the application of the LCR rule, regulatory capital rules, and enhanced prudential standards depends on an institution’s category. It was contemplated that the application of the NSFR rule would largely track the revised LCR rule.

As expected, the NSFR rule adopts the categories approach. Covered companies for purposes of the NSFR rule will consist of Category I institutions, Category II institutions, and some Category III institutions (i.e., those with $75 billion or more in average weighted short-term wholesale funding (wSTWF)). A modified version of the NSFR rule will apply to smaller covered companies, which are other Category III institutions and certain Category IV institutions (i.e., those with $50 billion or more in average wSTWF).

Net Stable Funding Ratio

The NSFR is intended to ensure that a covered company has adequate long-term stable funding, in contrast to the LCR’s focus on short-term funding adequacy. The NSFR rule will require a covered company to maintain an amount of available stable funding (ASF) that is not less than the amount of its required stable funding (RSF) on an ongoing basis. A smaller covered company will be required to maintain an ASF of at least 70 percent of its RSF if it is a Category IV institution with $50 billion or more in average wSTWF or 85 percent of its RSF if it is a Category III institution with less than $75 billion in average wSTWF. A covered company’s NSFR will be expressed as a ratio of its ASF amount (the NSFR numerator) to its RSF amount (the NSFR denominator). A covered company’s ASF amount will serve as a weighted measure of stability of the company’s funding over a one-year time horizon, but not otherwise “stressed,” as is the case for the LCR.

A covered company will calculate its ASF amount by applying specified standardized weightings (ASF factors) to its equity and liabilities based on their expected stability. Similarly, a covered company will calculate its RSF amount by applying specified standardized weightings (RSF factors) to its assets, derivative exposures, and commitments based on their liquidity characteristics. These characteristics include credit quality, tenor, encumbrances, counterparty type, and characteristics of the market in which an asset trades, as applicable.

Available Stable Funding Amount (NSFR Numerator)

As with the 2016 proposal, a covered company’s ASF amount will be equal to the sum of the carrying values of the covered company’s NSFR regulatory capital elements (generally, Tier 1 and Tier 2 capital elements) and NSFR liabilities (generally, all other balance sheet liabilities and equity elements), each multiplied by a specified ASF factor. The Agencies set the ASF factors based on the stability of each category of NSFR liability or NSFR regulatory capital element over the NSFR’s one-year time horizon. The Agencies explicitly rejected a request to exclude on-balance sheet securitization exposures and cited the funding support that banking organizations provided for securitization exposures during the 2008 financial crisis.

A covered company will be able to include in its ASF amount the ASF amount of a consolidated subsidiary only to the extent that the funding of the subsidiary supports the RSF amount associated with its own assets or is readily available to support RSF amounts associated with the assets of the covered company outside the consolidated subsidiary.

ASF Factor Characteristics

The NSFR rule will use a set of ASF factors to measure the relative stability of a covered company’s NSFR liabilities and NSFR regulatory capital elements over a one-year time horizon. The Agencies scaled the ASF factors from zero to 100 percent, with zero percent representing the lowest stability and 100 percent representing the highest stability. In a notable change from the proposal, the NSFR rule assigned a 50 percent ASF factor (instead of zero percent) to retail funding that is not in the form of a deposit or a security issued by the covered company to reflect suggestions from commenters regarding the stability of such liabilities.

As with the proposal, the NSFR rule assigns an ASF factor to a particular category of NSFR liabilities or NSFR regulatory capital elements based on three characteristics relating to the stability of the funding, as applicable: (i) funding tenor, (ii) funding type, and (iii) counterparty type.

Funding Tenor

The NSFR rule generally treats funding that has a longer effective maturity as more stable than shorter-term funding. The NSFR rule groups funding maturities into four categories: (i) less than six months, (ii) six months or more but less than one year, (iii) less than one year, and (iv) one year or more.⁵ The NSFR rule will treat loans to the covered company with a remaining maturity of one year or more as the most stable (subject to a 100 percent ASF factor), and will treat a loan with a remaining maturity of less than six months or an open maturity as the least stable (subject to a 0 percent ASF factor). The NSFR rule will treat a loan from a financial sector or non-financial sector entity that matures in six months or more but less than one year as partially stable (subject to a 50 percent ASF factor).

Funding Type

The NSFR rule recognizes that certain types of funding are inherently more stable than other types, independent of stated tenor. For example, the NSFR rule assigns a higher ASF factor to stable retail deposits (as defined in the LCR rule) relative to other retail deposits, due in large part to the presence of deposit insurance coverage and other stabilizing features that reduce the likelihood of a depositor discontinuing the funding across a broad range of market conditions. Similarly, the NSFR rule assigns a higher ASF factor to operational deposits (unsecured wholesale funding necessary for clearing, custody, or cash management services) than to certain other forms of short-term, wholesale deposits based on the provision of services linked to an operational deposit. Likewise, the NSFR rule assigns different ASF factors to different categories of retail brokered deposits based on features that tend to make these forms of deposit more or less stable.⁶

Counterparty Type

The NSFR rule recognizes that the stability of a covered company’s funding also may vary based on the type of counterparty providing it. Accordingly, the NSFR rule treats most types of funding provided by retail customers or counterparties as more stable than similar types of funding provided by wholesale customers or counterparties. It also generally treats short-term funding provided by financial sector entities as less stable than similar types of funding provided by non-financial wholesale customers or counterparties.

NSFR Consolidation

In general, the NSFR rule will require a covered company to calculate its NSFR on a consolidated basis. When calculating ASF amounts available from a consolidated subsidiary, the NSFR rule requires a covered company to take into account restrictions on the ASF of the consolidated subsidiary to support assets, derivative exposures, and commitments of the covered company held at entities other than the subsidiary. Specifically, a covered company will only be able to include in its ASF amount any portion of a consolidated subsidiary’s “excess” (i.e., ASF amounts in excess of the consolidated subsidiary’s RSF amount) to the extent the consolidated subsidiary may transfer assets to the top-tier entity of the covered company, taking into account statutory, regulatory, contractual, or supervisory restrictions. These restrictions may be derived from US law (e.g., Sections 23A and 23B of the Federal Reserve Act) or foreign law (e.g., ring-fencing regimes).

Required Stable Funding Amount (NSFR Denominator)

Under the NSFR rule, a covered company’s RSF amount will represent the minimum level of stable funding that the covered company must maintain. A covered company’s RSF amount will be based on the liquidity characteristics of its assets, derivative exposures, and commitments. In general, the less liquid an asset over the NSFR’s one-year time horizon, the greater extent to which the NSFR rule will require it to be supported by stable funding. By requiring a covered company to maintain more stable funding to support less liquid assets, the NSFR rule is designed to reduce the risk that the covered company could be required to monetize the assets for less than full value, including potentially at fire sale prices, or otherwise in a manner that contributes to disorderly market conditions.

RSF Factor Characteristics

As with the proposal, the NSFR rule will use a set of standardized weightings, or RSF factors, to determine the amount of stable funding a covered company must maintain. Specifically, a covered company will calculate its RSF amount by multiplying the carrying values of its assets, the undrawn amounts of its commitments, and its measures of derivative exposures by the assigned RSF factors. RSF factors will be scaled from zero percent to 100 percent based on the liquidity characteristics of an asset, commitment, or derivative exposure.

Under the NSFR rule, a zero percent RSF factor will not require the asset, derivative exposure, or commitment to be supported by ASF and a 100 percent RSF factor will require the asset, commitment, or derivative exposure to be fully supported by ASF. Accordingly, the NSFR rule generally assigns a lower RSF factor to more liquid assets, commitments, and exposures and a higher RSF factor to less liquid assets, commitments, and exposures. Interestingly, RSF factors are not linked to ASF factors, and neither one is directly linked to the LCR ratio. Additionally, it is notable that the Agencies responded to the commenters and the results of a staff analysis by changing the RSF factors for unencumbered level 1 liquid assets (e.g., Treasury securities) and well-secured short-term lending transactions with financial sector counterparties to assume that a covered company can liquidate 100 percent of its holdings within a one-year time horizon (instead of 95 percent and 90 percent under the proposal, respectively).⁷

For purposes of assigning a specific RSF factor, the NSFR rule will measure expected liquidity over the NSFR rule’s one-year time horizon based on the following characteristics, considered collectively for each asset, as applicable: (i) credit quality, (ii) tenor, (iii) type of counterparty, (iv) market characteristics, and (v) encumbrance.

Credit Quality

Credit quality is a factor in an asset’s liquidity because the Agencies view market participants as tending to be more willing to purchase higher credit quality assets across a range of market and economic conditions, but especially in a stressed environment (sometimes called “flight to quality”). Thus, demand for higher credit quality assets is more likely to persist and such assets are more likely to have resilient values, allowing a covered company to monetize them more readily.

Assets of lower credit quality, in contrast, are more likely to become delinquent. That increased credit risk makes these assets less likely to hold their value. As a result, the NSFR rule generally will require assets of lower credit quality to be supported by more stable funding to reduce the risk that a covered company may have to monetize the lower credit quality asset at a discount.

Tenor

In general, the NSFR rule will require a covered company to maintain more stable funding to support assets that have a longer tenor because of the greater time remaining before the covered company will realize inflows associated with the asset. In addition, assets with a longer tenor may liquidate at a discount because of the increased market and credit risks associated with cash flows occurring further in the future. Assets with a shorter tenor, in contrast, will require a smaller amount of stable funding under the NSFR rule because a covered company is expected to have quicker access to the inflows from these assets. Thus, the NSFR rule generally will require less stable funding for shorter-term assets compared to longer-term assets. The NSFR rule divides maturities into four categories for purposes of a covered company’s RSF amount calculation: less than six months, six months or more but less than one year, less than one year, and one year or more.⁸

Counterparty Type

According to the Agencies, a covered company may face pressure to roll over some portion of its assets in order to maintain its franchise value with customers and because a failure to do so could be perceived by market participants as an indicator of financial distress at the covered company.

Typically, this risk is driven by the type of counterparty. For example, the Agencies note that covered companies often consider their lending relationships with a wholesale, non-financial borrower to be important to maintain current business and generate additional business in the future. As a result, a covered company may have concerns about damaging future business prospects if it declines to roll over lending to such a customer for reasons other than a change in the financial condition of the borrower. More broadly, because market participants generally expect a covered company to roll over lending to wholesale, non-financial counterparties based on relationships, a covered company’s failure to do so could be perceived as a sign of liquidity stress at the company, which could itself cause such a liquidity stress.

These concerns are less likely to be a factor with respect to financial counterparties because financial counterparties typically have a wider range of alternate funding sources already in place, face lower transaction costs associated with arranging alternate funding, and do not typically expect to maintain stable lending relationships with any single provider of credit. Therefore, the Agencies believe that market participants are less likely to assume that the covered company is under financial distress if the covered company declines to roll over funding to a financial sector counterparty. In light of these business and reputational considerations, the NSFR rule will require a covered company to more stably fund exposures to non-financial counterparties than exposures to financial counterparties, all else being equal.

Market Characteristics

Assets that are traded in transparent, standardized markets with large numbers of participants and dedicated intermediaries tend to exhibit a higher degree of reliable liquidity. The NSFR rule will, therefore, require less stable funding to support such assets than those traded in markets characterized by information asymmetry and relatively few participants.

Encumbrances

Whether and the degree to which an asset is encumbered will dictate the amount of stable funding that a covered company is required to maintain to support the particular asset, because encumbered assets cannot be monetized during the period over which they are encumbered. For example, securities that a covered company has pledged for a period of greater than one year in order to provide collateral for its longer-term borrowings are not available for the covered company to monetize in the shorter term. In general, the longer an asset is encumbered, the more stable funding the NSFR rule will require. An asset that is encumbered for less than six months from the calculation date will be assigned the same RSF factor as would be assigned to the asset if it were unencumbered.

Derivatives Transactions

The NSFR rule will calculate the stable funding requirement and available stable funding relating to a covered company’s derivative transactions as defined in the LCR rule. The calculation includes three components: (1) the current value of a covered company’s derivatives assets and liabilities; (2) the initial margin provided by a covered company pursuant to derivative transactions and assets contributed by a covered company to a central counterparty’s (CCP’s) mutualized loss sharing arrangement in connection with cleared derivative transactions; and (3) potential future changes in the value of a covered company’s derivatives portfolio. If the total derivatives asset amount exceeds the total derivatives liability amount, the covered company has an “NSFR derivatives asset amount,” which would be assigned a 100 percent RSF factor.

Conversely, if the total derivatives liability amount exceeds the total derivatives asset amount, the covered company has an “NSFR derivatives liability amount,” which will not be considered stable funding and would be assigned a zero percent ASF factor. Additionally, the NSFR will apply a 100 percent RSF factor to five percent (which is down from 20 percent in the proposal) of the derivative liability exposures to account for potential future changes to market values. It also will assign an 85 percent RSF factor to the fair value of assets contributed by a covered company to a CCP’s mutualized loss sharing arrangements, as this form of collateral is assumed to be maintained at levels similar to current levels.

The NSFR rule recognizes the effect of qualifying master netting arrangements in a similar fashion as the LCR rule and will permit covered companies to compute the value of QMNA netting sets prior to applying the NSFR calculation provisions. Further, in contrast to the proposal, the NSFR rule expands the types of variation margin that are eligible for netting.

Net Stable Funding Ratio Shortfall

The Agencies expect circumstances where a covered company has an NSFR shortfall to arise only rarely. The NSFR rule requires a covered company to notify its appropriate Federal banking agency of an NSFR shortfall or potential shortfall, that is, when a covered company’s NSFR falls below 1.0.

Specifically, a covered company will be required to notify its appropriate Agency no later than 10 business days, or such other period as the appropriate Agency may otherwise require by written notice, following the date that any event has occurred that has caused or would cause the covered company’s NSFR to fall below the minimum requirement. In addition, a covered company will be required to develop a plan for remediation in the event of an NSFR shortfall.

The Agencies state that they do not expect covered companies to incur significant costs to comply with the NSFR rule because the aggregate NSFR shortfall is currently in the range of $10 billion to $30 billion. The Agencies believe covered companies can remediate this shortfall prior to the implementation of the NSFR rule in 2021 by rebalancing their liabilities to favor liabilities with higher ASF factors (e.g., replacing 90 day commercial paper with 365 day commercial paper). According to the Agencies, the expected cost of this rebalancing is $80 million to $250 million per year. However, this statement is at sharp odds with industry predictions of adverse consequences, including that the “rebalancing” might be accomplished by banks exiting current lines of business and, when examined in combination with other regulatory reforms, may have significantly higher costs.⁹

Disclosure Requirements

The disclosure requirements of the NSFR rule will apply to covered companies that are bank holding companies and savings and loan holding companies. They will not apply to depository institutions. Disclosures must be made beginning 18 months after a covered company becomes subject to the NSFR rule, which means that the first public disclosures are required to be made approximately 45 days after the end of the second quarter of 2023.

The NSFR rule will require public disclosures of a company’s NSFR and its components to be made in a standardized tabular format (NSFR disclosure template). The NSFR rule will also require the disclosures to contain sufficient discussion of certain qualitative features of a covered company’s NSFR and its components to facilitate an understanding of the company’s calculation and results. A covered company will be required to provide the public disclosures for each calendar quarter in a direct and prominent manner on its public Internet site or in a public financial report or other public regulatory report, but will be permitted to report the information every second and fourth calendar instead of after each quarter (e.g., Q1 and Q2 disclosures must be posted after Q2).¹⁰ The disclosures will have to remain publicly available for at least five years from the date of the disclosure.

Modified NSFR for Smaller Covered Companies

FRB will apply a modified version of the NSFR to smaller covered companies, which are Category III institutions with less than $75 billion in average wSTWF and Category IV institutions with $50 billion or more in average wSTWF. Smaller covered companies that are Category III institutions would use the same ASF and RSF factors and calculations applicable to covered companies, but would need to hold ASF equal to 85 percent of RSF (in contrast to the 100 percent required of larger covered companies) and smaller covered companies that are Category IV institutions would need to hold ASF equal to 70 percent of RSF. The modified NSFR rule would apply only at the holding company level of a smaller covered company that is a Category IV institution.

Conclusion

The NSFR rule will become effective on July 1, 2021. The Agencies expect this deadline to allow for sufficient time for covered companies to implement infrastructure and operational changes. However, in light of the new definitions and granular data that must be used with the NSFR rule, we expect that covered companies will encounter many interpretive questions and spend significant time and resources complying with it by the effective date. Furthermore, ongoing compliance after the effective date is likely to present additional challenges for covered companies.