NSFR opens up new front in war on repo

The US Federal Reserve wants to make repo trades more expensive and views still-pending rules on bank funding as one policy lever. However, a new draft of those rules goes too far, banks argue, potentially driving up costs by more than 850%. Lukas Becker reports

US Federal Reserve

If the repo market was a cartoon character it would be Scratchy, the unfortunate cat in occasional episodes of The Simpsons. If Scratchy avoids falling into a vat of acid, it means a swarm of flesh-eating bees is just round the corner; if he then leaps into a taxi to avoid them, an even worse fate lies in store. Of course, when all of this happens to an animated cat, it's funny, but those in the repo market are not getting the joke.

On January 12, the industry celebrated its latest reprieve when the Basel Committee on Banking Supervision made a number of vital concessions in its final version of the leverage ratio. But banks failed to notice the flesh-eating bees hidden in the committee's draft of the net stable funding ratio (NSFR), published at the same time.

"It was not until sometime after January that people began to realise that securities financing transactions are defined as loans, and that secured lending to non-banks was going to be treated in the same way as unsecured lending. That's big, and has the potential to dramatically impact the funding markets," says Andy Hill, a director at the International Capital Market Association (Icma) in London.

Working groups were convened, serial conference calls held and the lobbying machine cranked back into high gear – a public affairs specialist at one European bank jetted to the US from London solely to gate-crash a supervisory seminar where the repo market was on the agenda. One bank's rough estimate is of an 850% rise in the cost of a simple US Treasury reverse repo, from around 7 basis points today to 67bp if the draft NSFR is implemented.

This price rise could filter back into financing costs, with investors demanding more yield to make up for the cost of borrowing securities, and would dramatically cut the liquidity in reverse repo markets, bankers warn. It would also force banks to raise significant amounts of funding – early calculations by banks and industry groups put it at hundreds of billions of dollars.

It was not until the beginning of March when everyone recognised this was going to impact repo, and would hit the market like nothing we’ve seen before

It's not just repos that would suffer, though – the rules put equities, trade finance and derivatives activities under pressure (see box, Other concerns: derivatives netting, emerging markets and more). "There are a number of areas where actual funding liquidity issues are not fully recognised and will, if not corrected, have a substantial impact on important businesses and important products," says David Schraa, director of regulatory affairs at the Institute of International Finance in Washington, DC.

The industry's hope is that this is an unintended effect and will be corrected by regulators. They were given some encouragement in early April, when the chair of the Basel Committee's liquidity working group – Sylvie Matherat, deputy director-general in the Banque de France's directorate of general operations – told a Risk conference in London that regulators "are very concerned by the consequences and impact of regulation in some markets; for example, the repo market. In my discussion with bankers, I've had the impression that maybe there will be some impact on the repo market that is not intended".

This hope is undercut by public statements from some US regulators, including Daniel Tarrullo, a Federal Reserve Board governor, who identified the NSFR as a potential policy tool, the aim being to make repo and securities lending more expensive.

The NSFR tries to make banks more resistant to liquidity risk by pushing them away from short-term wholesale funding. The ratio is calculated by dividing a bank's available stable funding (ASF) by its required stable funding (RSF), with a minimum of 100%. The ASF and RSF totals are determined by applying a regulator-set multiplier to bank assets and liabilities.

For repo, the problem is that the January proposals apply an asymmetrical treatment to trades with non-banking entities such as money market funds and asset managers, which are big users of it. According to an Icma survey last December, around 37% of reverse repos are transacted with these entities.

The draft rules say unencumbered loans – which includes reverse repos – with non-bank financial institutions such as asset managers receive a 50% RSF. However, the opposite repo trade with a non-bank financial institution receives a 0% ASF.This means that for every $100 lent to these counterparties via a reverse repo, US$50 of term funding would be required.

"The NSFR proposal is a concern, as it introduces an asymmetry between repo and reverse repo with non-bank financials. This effectively means a short-term reverse repo would generate a requirement for long-term stable funding. So, in effect, though you may be lending overnight, you need to back it up with 100% of six-month financing or 50% of one-year financing," says Eric Litvack, head of regulatory strategy at Societe Generale Corporate & Investment Banking.

The IIF says it has held more than 20 calls on the NSFR since the start of March, while Icma has produced a study looking at its impact on the repo market in particular.

The results are startling. Banks currently charge around 7bp for an overnight US Treasury reverse repo, according to Maureen Coen, fixed-income department treasurer at Credit Suisse in New York, but if term funding is required for half the notional, she estimates it could add up to 60bp to the cost of the transaction. The lion's share would probably be passed on to end-users, she adds.

"A rational business case could be to pass the cost on to the customer, so that would drive up the overnight repo rate to 67bp. That's just a hypothetical example, looking at reasonable long-term debt and the range where most banks would issue, but I think that's within the realm of possibilities in terms of how much additional cost could be allocated to that overnight repo by the current draft," says Coen.

This could have a knock-on effect on the price of government securities. "If the reverse repo counterparty absorbs that 67bp, they're going to want higher yields on whatever treasuries they buy to have parity with where they are today," she argues.

Liquidity in the repo market could also take a hit. Coen says the impact of the NSFR, combined with the final version of the leverage ratio, could lead banks to retreat from securities lending. If they reduced their reverse repo business by 20%, she believes it would remove US$1 trillion of financing capacity from the market.

Icma's Hill says a 20% retreat from the reverse repo market is a conservative estimate, given the historically small margins made by banks from repo and the extra burdens it attracts under the leverage ratio.

"If you have to put 50% stable funding aside to support that business, it becomes economically unviable and it's just not going to happen. A big chunk of the market is going to vanish – a drop of 20% sounds on the low side to me," says Hill.

This could concentrate the market in fewer hands or create an incentive for repo funding customers to rely more on non-banking counterparties, thus increasing the size of the shadow banking system, warns Credit Suisse's Coen.

Foreign banks with US business have already signalled their retreat from the market as a result of rules requiring them to hold capital and liquidity locally (Risk April 2014). And pension funds in particular are increasingly concerned the market will not allow them to repo assets in large enough quantities to meet calls for cash margin during periods of market stress (Risk December 2013).

Issuers are paying attention, too: "From our perspective, anything that would potentially affect market liquidity is something we might want to look at, so no doubt we will be watching closely how this evolves," says Robert Stheeman, chief executive of the UK Debt Management Office in London.

Icma's official response to the NSFR proposals highlights other issues. First, it argues secured and unsecured funding should not be treated in the same manner, recommending that reverse repos with maturities under 12 months and secured with the highest-quality liquid assets should receive a 0% RSF factor.

It also asks for the definition of financial counterparty to be clarified. Initially, it was thought central counterparties and the banks' internal broker-dealers would count as a non-bank financial entity and thus attract the 50% RSF factor. However, guidance is understood to have come from Basel's liquidity working group that they can be treated as a bank subject to prudential supervision, receiving a 0% RSF for trades with residual maturities of under six months.

The Icma comment letter pushes this further, calling for the bank category to include central banks and financial institutions subject to prudential regulation for liquidity and capital purposes – a definition that could include a number of large asset managers under the Financial Stability Board's proposed rules for systemically important institutions that are neither banks nor insurers.

The group also calls for recognition of repos linked to the financing of bank or client short positions, given their importance to secondary market-making. "We think it's a critical function and helps protect the secondary market. We ask that these have an RSF factor of zero, or a symmetrical approach with an ASF and RSF that negate each other," says Hill.

The analysis has been credible enough to get the attention of Banque de France's Matherat at least, but some industry sources dispute the idea that the rule's impact was an oversight, claiming some bank supervisors are trying to shrink the repo market. The Fed's Tarrullo gave weight to that theory in a speech on the topic of shadow banking last November, when he outlined ways of making securities financing more expensive and, he argued, reducing systemic risk.

"With the NSFR still under discussion, and the Basel Committee in the process of reconsidering the standardised banking book risk weights and capital regulations associated with traded assets, there are opportunities to pursue these options," he said.

But the Fed may be isolated. Industry participants say they are not aware of any European regulators that share the US supervisor's concerns about the repo market. The IIF's Schraa argues national regulators should not useinternational liquidity standards to tackle local issues.

Aside from repos, the equities market is in the firing line. The NSFR rules place a 50% RSF on exchange-traded common equity shares not issued by financial institutions, an 85% RSF requirement on exchange-traded financial stocks, and a 100% RSF for non-exchange-traded equities, meaning simply holding these instruments for market-making purposes will require significant extra funding.

Delta-one trading desks could suffer, because they often trade total return swaps – attracting a funding requirement under certain circumstances – hedged by the underlying equities, but the NSFR will not recognise a link between the two, meaning they would have separate funding requirements. Similarly, it would hurt equity futures trading businesses that require banks to hedge their short-term exposures in the cash equities market, which again need to be funded by long-term debt.

As with the repo market, a senior executive in the equities department at a European bank says the extra funding costs could be passed on to clients in the form of wider bid-offer spreads. "What happens is that transaction costs for pension funds rise and the returns on their portfolios suffer. Higher costs also translate into lower liquidity in the markets. It all trickles down to the end-users while at the same time generating a certain amount of market disruption, as well as liquidity and efficiency concerns," he says.

Industry concerns about these linked, offsetting positions were acknowledged by the Banque de France's Matherat in her remarks at the conference: "You may have a short-term position in equities that is funded by reverse repo, and we didn't take that specifically into account, so we may have to change that."

One European bank's head of public policy for Europe, the Middle East and Africa describes Matherat's comments as "encouraging", but says nothing is certain until the final rules are completed.

The Basel Committee is believed to be aiming to complete the NSFR rules in time for the G-20 leaders' meeting in Brisbane on November 15 and 16. But given the amount of work that needs to be done, market participants are concerned they may end up being rushed.

"Whether they will have the time to really evaluate all the things that might be refined to arrive at the best possible NSFR, I don't know. I do hope they will leave the door open to further refinements, especially if market effects develop in the way people are concerned they might," adds the IIF's Schraa.

 

BOX: Other concerns: derivatives netting, emerging markets and more

Derivatives netting: The draft net stable funding ratio states that if derivatives payables and receivables are netted and payables are larger, they receive a 0% available stable funding (ASF) factor. If the receivables are larger, they receive a 100% required stable funding (RSF) factor.

In its Basel III monitoring guidelines, updated in January, the Basel Committee elaborated slightly, saying netting would be done using regulatory standards rather than accounting ones, but David Schraa, director of regulatory affairs at the Institute of International Finance in Washington, DC says the proposed treatment is still too vague, especially regarding the treatment of collateral.

"Just getting clarity and making sure netting works and is focused on liquidity issues as opposed to credit issues will be very important. Making sure collateral is appropriately taken into account will be essential to avoid undue burdens on the business," says Schraa.

Trade finance: These loans attract a 50% RSF – too conservative, say lobbyists, given the relatively sedate nature of the business. "It isn't something that can be gamed for funding purposes. It isn't dangerous maturity transformation," says Schraa.

The NSFR would give national regulators discretion to set their own RSF factor for trade finance held off the balance sheet, but industry groups argue this could lead to inconsistencies across jurisdictions.

Covered bonds: The securities are classed as an encumbered asset in the NSFR text, so banks' holdings attract a 100% RSF while the underlying mortgages only attract a 65% RSF. That could discourage banks from using the market, critics claim.

Emerging markets: South Africa's banks have long complained the NSFR would disadvantage economies with less developed retail deposit markets, where banks are forced to rely more on wholesale funding.

Wholesale funding makes up around 40% of bank funding in South Africa, but the January proposals only give a 50% ASF to money-market funding with a residual maturity of between six months and one year, while so-called operational deposits, which include clearing, custody and cash management activities, also get a 50% weighting. That is better than the levels in the original version of the NSFR, but would still make compliance difficult for South African banks – and the country's central bank wants changes to be made by the Basel Committee on Banking Supervision.

"It's important for us to see that whatever concerns we have, which we have voiced in the international fora, somehow get accommodated, because it isn't just us – other jurisdictions have similar challenges," said South Africa Reserve Bank deputy governor Daniel Mminele, speaking at the Risk South Africa conference in Cape Town in March.