Adjusted long term liquidity ratio

What Is the Net Stable Funding Ratio (NSFR)?

The Net Stable Funding Ratio (NSFR), sometimes referred to as the Adjusted Long-Term Liquidity Ratio, is a key metric within financial regulation designed to ensure that banks maintain a stable funding profile over a one-year horizon. It is a fundamental tool for liquidity risk management within the banking sector. The NSFR encourages financial institutions to fund their long-term assets with sufficiently stable sources of funding, thereby reducing the likelihood that disruptions to a bank's regular sources of funding will compromise its liquidity position or lead to broader systemic risk. The NSFR is a critical component of the Basel III framework, which aims to enhance financial stability globally.

History and Origin

The concept of a long-term stable funding requirement emerged in the aftermath of the 2008 global financial crisis. During this period, many banks, despite appearing well-capitalized, experienced severe liquidity crises due to an over-reliance on volatile, short-term wholesale funding²⁹. This highlighted a critical gap in existing regulatory frameworks, which had primarily focused on capital adequacy rather than the stability of funding sources.

In response, the Basel Committee on Banking Supervision (BCBS), an international body of banking supervisors, developed Basel III, a comprehensive set of reforms to strengthen the regulation, supervision, and risk management of the banking sector²⁷, ²⁸. The NSFR was proposed in 2009 and formally included in the December 2010 Basel III agreement²⁶. After a rigorous review process and recalibration to better reflect funding risk profiles, a revised standard for the NSFR was issued in January 2014, with a global implementation target of January 1, 2018²⁵. In the United States, federal bank regulatory agencies, including the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC), finalized their rule to implement the NSFR in October 2020, with an effective date of July 1, 2021²², ²³, ²⁴. The NSFR is intended to ensure that banks can continue to provide financial intermediation even during adverse market conditions²¹.

Key Takeaways

• The Net Stable Funding Ratio (NSFR) is a long-term liquidity standard requiring banks to maintain stable funding for their assets and off-balance sheet activities over a one-year horizon.
• It is a core component of the global Basel III regulatory framework, designed to prevent future liquidity crises.
• The NSFR helps mitigate the risks associated with excessive reliance on short-term or unstable funding sources.
• A ratio of 100% or greater indicates that a bank has sufficient stable funding to meet its long-term obligations.
• The NSFR complements the Liquidity Coverage Ratio (LCR), which addresses short-term liquidity risks.

Formula and Calculation

The Net Stable Funding Ratio is calculated as the ratio of a bank's Available Stable Funding (ASF) to its Required Stable Funding (RSF). The NSFR must be equal to or greater than 100% on an ongoing basis²⁰.

The formula for the NSFR is:

Where:

• Available Stable Funding (ASF) refers to the portion of a bank's regulatory capital and liabilities that are expected to be reliable sources of funding over a one-year period. Different categories of capital and liabilities are assigned an "ASF factor" ranging from 0% to 100% based on their stability¹⁹. For instance, common equity is considered 100% stable, while short-term wholesale funding generally has a lower ASF factor.
• Required Stable Funding (RSF) represents the amount of stable funding a bank needs based on the liquidity characteristics and residual maturities of its assets and off-balance sheet exposures. Assets and off-balance sheet items are assigned an "RSF factor" (from 0% to 100%) that reflects the amount of stable funding required to support them. More illiquid assets or those with longer maturities require a higher RSF factor¹⁷, ¹⁸. For example, high-quality liquid assets might require a 0% RSF factor, while less liquid assets or encumbered assets with a maturity of one year or more would attract a 100% RSF factor¹⁶.

Interpreting the NSFR

An NSFR of 100% or above signifies that a bank possesses enough stable funding to cover its long-term asset base and off-balance sheet activities, thereby promoting greater resilience against unexpected funding shocks. A ratio below 100% indicates a potential over-reliance on short-term or less stable funding sources, which could expose the institution to liquidity risk if market conditions deteriorate or investor confidence wanes.

Regulators utilize the NSFR to ensure that banks manage their maturity transformation activities prudently. While maturity transformation—borrowing short-term and lending long-term—is a fundamental banking function, an excessive imbalance can lead to instability. The NSFR encourages banks to lengthen the maturity of their funding sources or shorten the maturity of their assets to align their funding profile with the long-term liquidity needs of their balance sheet. This metric helps supervisors assess the structural soundness of a bank's funding and its capacity to withstand a prolonged period of funding stress.

Hypothetical Example

Consider "Horizon Bank," a hypothetical financial institution. To calculate its NSFR, the bank first identifies its Available Stable Funding (ASF) and Required Stable Funding (RSF).

Available Stable Funding (ASF):

• Common Equity: $100 million (100% ASF factor) = $100 million
• Customer Deposits (stable portion): $300 million (90% ASF factor) = $270 million
• Long-term wholesale funding (over 1 year): $150 million (100% ASF factor) = $150 million
• Short-term wholesale funding (less than 1 year, less stable portion): $50 million (50% ASF factor) = $25 million
  • Total ASF = $100 + $270 + $150 + $25 = $545 million

Required Stable Funding (RSF):

• High-Quality Liquid Assets: $80 million (0% RSF factor) = $0 million
• Loans to customers (with residual maturity over 1 year): $400 million (85% RSF factor) = $340 million
• Derivatives exposures: $30 million (variable RSF factor, let's assume 50% for simplicity) = $15 million
• Other illiquid assets: $100 million (100% RSF factor) = $100 million
  • Total RSF = $0 + $340 + $15 + $100 = $455 million

Now, calculate the NSFR:

In this example, Horizon Bank's NSFR of approximately 119.78% indicates that it holds more stable funding than required, suggesting a robust long-term liquidity position. This helps the bank manage its credit risk exposure by ensuring it has stable funding for its lending activities.

Practical Applications

The Net Stable Funding Ratio (NSFR) has several key practical applications in the financial sector:

• Banking Supervision and Regulation: The primary application of the NSFR is in banking supervision. Regulatory bodies globally use the NSFR to assess and enforce the long-term funding stability of banks. It helps supervisors ensure banks have a sustainable funding structure, reducing the risk of a liquidity crisis that could ripple through the financial system.
• ¹⁴, ¹⁵ Liquidity Risk Management: Banks actively use the NSFR internally to guide their liquidity risk management strategies. It incentivizes them to diversify their funding sources, favor more stable forms of liabilities (like long-term customer deposits over short-term wholesale funding), and align the maturities of their assets and liabilities.
• Investor and Analyst Evaluation: Financial analysts and investors scrutinize a bank's NSFR as part of their assessment of its financial health and resilience. A strong NSFR can signal a lower funding risk profile, potentially making the bank a more attractive investment.
• Strategic Planning and Asset-Liability Management (ALM): The NSFR influences a bank's strategic decisions regarding asset growth, loan portfolios, and funding mix. It promotes sound asset-liability management by encouraging banks to consider the stable funding implications of their balance sheet composition over a longer horizon.
• Macroprudential Policy: Beyond individual bank stability, the NSFR contributes to macroprudential policy goals by reinforcing overall financial stability. By limiting the reliance on unstable funding across the banking system, it aims to reduce the likelihood of widespread liquidity shocks, as highlighted in reports by institutions like the International Monetary Fund (IMF) concerning potential liquidity risks in financial markets.

#¹², ¹³# Limitations and Criticisms

While the Net Stable Funding Ratio (NSFR) is a vital tool for promoting financial stability, it is not without its limitations and criticisms.

One common criticism is that the NSFR, like other Basel III regulations, can potentially increase the cost of credit and reduce profitability for banks. By¹⁰, ¹¹ requiring banks to hold more stable, often lower-yielding, assets or to rely on more expensive long-term funding, it could lead to higher lending rates for businesses and individuals, potentially hindering economic growth. So⁹me argue that the conservative nature of the NSFR's calibration might be overly cautious, particularly for certain market segments or banking models.

A⁸nother concern revolves around its potential impact on market liquidity. Critics suggest that by discouraging certain forms of market-based funding or by encouraging banks to hold highly liquid but low-return assets, the NSFR could inadvertently reduce the overall liquidity in financial markets. This could make it harder for banks to intermediate in certain areas or for non-bank financial institutions to access funding, especially during times of stress.

F⁷urthermore, the standardized nature of the NSFR, while promoting consistency, may not fully capture the unique risk profiles or business models of all banks. The application of fixed stable funding factors to broad categories of assets and liabilities might not perfectly reflect the true stability of funding or the liquidity characteristics of assets in all jurisdictions or under all market conditions. There are also debates about potential "loopholes" or unintended consequences where the regulation might shift risk-taking behavior from regulated banks to less regulated parts of the financial system.

#⁵, ⁶# Net Stable Funding Ratio vs. Liquidity Coverage Ratio (LCR)

The Net Stable Funding Ratio (NSFR) and the Liquidity Coverage Ratio (LCR) are both crucial liquidity requirements introduced under Basel III, but they address different aspects of a bank's liquidity risk profile.

While the LCR mandates that banks hold enough liquid assets to survive a short-term liquidity crunch, the NSFR ensures that banks have a more stable and sustainable funding structure for their longer-term activities. They are complementary ratios, with the LCR addressing immediate liquidity needs and the NSFR focusing on the structural resilience of a bank's funding over an extended period.

#², ³, ⁴# FAQs

Q: What is stable funding in the context of the NSFR?
A: Stable funding refers to sources of capital and liabilities that are expected to be reliable over a one-year horizon. This includes categories such as regulatory capital, long-term debt, and certain types of deposits (e.g., retail deposits or stable corporate deposits), which are less likely to be withdrawn during periods of financial stress.

Q: Why was the Net Stable Funding Ratio introduced?
A: The NSFR was introduced as part of the Basel III reforms in response to the 2008 financial crisis. Many banks experienced severe liquidity crises during that period due to their over-reliance on unstable, short-term funding for long-term assets. The NSFR aims to prevent a recurrence of such issues by requiring banks to maintain a more stable funding structure and manage their funding risk more effectively.

Q: Does the NSFR apply to all financial institutions?
A: The NSFR is primarily designed for large, internationally active banks and other significant financial institutions. The specific scope of application and calibration of the ratio can vary by jurisdiction, as national regulators implement the Basel III standards into their domestic rules.

¹Q: How does the NSFR impact a bank's business?
A: The NSFR incentivizes banks to shift away from excessive reliance on short-term wholesale funding and towards more stable, longer-term sources. This can influence a bank's lending policies, encouraging it to align the maturity of its loans with its stable funding base. It also encourages a stronger balance sheet structure, enhancing overall financial stability.

Q: Is the NSFR a capital requirement?
A: No, the NSFR is a liquidity requirement, not a capital requirement. While regulatory capital is considered a highly stable source of funding and contributes to the numerator of the NSFR, the ratio's primary focus is on the stability of a bank's funding profile relative to its assets and off-balance sheet exposures, rather than its capital adequacy in relation to risk-weighted assets.