Repo desks up in arms about NSFR

The cost of some repo transactions would leap 850% under a draft version of the NSFR, banks claim. One regulator admitted last week there could be unintended harm to the market and implied the rules could change

Basel Committee on Banking Supervision headquarters

Bank lobbyists are mobilising to combat a new threat to the repo market, which they claim could drive up the cost of some transactions by more than 850% – from seven basis points today, to 67bp if Basel III's net stable funding ratio (NSFR) is implemented as outlined in January. That 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 available in reverse repo markets, bankers warn.

Estimates of the impact are rough, but industry sources say the problem – which arises because banks would be required to hold term funding equal to half the size of some transactions – was only spotted in early March. Since then, one industry working group is said to have held more than 20 calls on the topic, while another is thought to be working on a full impact study.

"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 a source at one industry group.

The early analysis has been credible enough to get the attention of regulators. Speaking at a Risk conference in London last week, the chair of the Basel Committee on Banking Supervision's liquidity working group, Sylvie Matherat, alluded to the problems during a roundtable discussion.

"We are very concerned by the consequences and impact of regulation in some markets, for example the repo market. In my discussion with bankers, I have had the impression that maybe there will be some impact on the repo market that is not intended," said Matherat, who is also a deputy director-general at the Banque de France.

The NSFR proposal is a concern as it introduces an asymmetry between repo and reverse repo with non-bank financials

Some industry sources dispute the idea that the impact would be unintended. They claim some bank supervisors want to shrink the repo market, and point to a string of other new rules in which repo was initially treated harshly. It was the simultaneous publication of the final, more favourable, text for one of these – the leverage ratio – that initially distracted the industry from the problems in the NSFR, says one lobbyist.

In a speech on the topic of shadow banking last November, Federal Reserve Board governor Daniel Tarrullo outlined ways of making securities financing more expensive and, he argued, reducing the systemic risks posed by the market. "With the NSFR still under discussion, and with 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.

The NSFR seeks to make banks more resistant to liquidity risk by pushing them away from short-term wholesale funding. It is calculated by dividing the 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.

The problem is that the January proposals introduce an asymmetrical treatment for repos when conducted with non-bank financial entities such as money market funds and asset managers, which are big users of repo.

The draft rules state that if a bank acts as the security lender in a repo with a maturity of less than six months, it would attract a 50% RSF. This is matched by a 50% ASF if the counterparty is a non-financial corporate, meaning there is no net funding need, but the ASF drops to 0% for trades with non-bank financials – for every $100 dollars lent out, $50 of term funding would be needed.

"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.

Banks currently charge around 7bp for an overnight US Treasury 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 transaction's cost. The lion's share of that would probably be passed on to end-users, she adds.

"A rational business case could be to pass the cost onto 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.

That could produce 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 banks reduced their reverse repo business by 20%, she says, it would remove $1 trillion of financing capacity from the market. In turn, this could threaten the ability of pension funds to repo out their assets to meet cash variation margin calls on cleared derivatives portfolios – a scenario that is already causing concern.

It would also leave the market more concentrated, and create a big incentive for end users of repo funding to move their sources away from banks and into the shadow bank system, adds Coen.

Last week's comments from the Banque de France's Matherat are thought to be the first time a regulator has spoken about the issue publicly. She said the Basel Committee's working group might have been guilty of looking at bank funding from a balance-sheet point of view and overlooking the fact that certain activities are funded by certain liabilities – potentially indicating a softening of the rules in some situations.

"For example, 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," she said.

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 proposals are open for comment until April 11.