The net stable funding ratio is a rule which obliges banks to match longer-term assets and liabilities. Most regulators already use this some version of ALM matching to assess bank health, but the NSFR keeps the rules very simple, which can lead to major market distortions.
Different assets have different “required stable funding” ratios, while liabilities of different types can meet these requirements to varying extents.
Unencumbered mortgages (of whatever kind) require stable funding of 65%, meaning a bank that funds these with senior unsecured debt (providing 100% stable funding while dated longer than one year), has an NSFR above 100%.
However, if the mortgage loans are encumbered, such as those that form part of a covered bond pool, they need 100% stable funding. Cover pools will typically secure some bonds with maturities below 1 year, and be larger than the bonds they support (thanks to overcollateralisation requirements) so the NSFR in this situation will be below 100%.
These rules therefore encourage banks to issue senior unsecured debt over covered bonds, despite the proven success of covered bonds as a source of stable funding in volatile times and when access to the capital markets is uncertain.
The regulation also does not credit the longer maturities available in the covered bond market – it distinguishes between less than one year and more than one year, but makes no distinction between five years and 10.
The covered bond market’s capacity to provide funding with a long duration has helped banks to match the long duration of their mortgage assets with long liabilities. This capacity to match fund is something that is seen positively by credit rating agencies because it reduces the probability of a bank defaulting. Perhaps the Basel Committee knows something the rating agencies don’t.
Or maybe they just got it wrong.
The NSFR privileges deposit funding over covered bonds even though, as Northern Rock’s failure showed, retail deposits can quickly flee a bank. Unlike the people that queued up around corners to withdraw their deposits from the stricken UK bank, the funding provided by its covered bonds was good until maturity.
Yet the Basel committee promotes deposits over covered bonds in the calculation of the NSFR, including deposits that are not under the deposit guarantee insurance scheme. Overnight funding, if in deposit form, is considered stronger than the term funding provided by covered bonds.
As such banks will be incentivised to use fewer covered bonds and their funding will become more unstable.
This is particularly so in countries that have a long and successful history of issuing covered bonds and which also boast among Europe’s strongest and most stable banks – such as those in Sweden. Not surprisingly Swedish bankers are incensed about the proposals.
“The NSFR proposal provides incentives for banks, which currently fund retail mortgage loans with Triple-A instruments ‒ with well-documented and proven availability and stability even under stressed conditions ‒ to change the funding mix towards more unstable funding sources,” said the Swedish Bankers Association in a letter to the BCBS last week,
Covered bond bankers are aware of the risks of encumbrance and are not asking for their market to be put on an equal footing with senior unsecured in this respect. Clearly encumbered mortgages should require more stable funding than unencumbered. The Swedish bankers association suggests a compromise at 85% stable funding, against 100% in the present proposals. Let’s hope the Basel Committee takes the advice on board.