NSFR may clear up questions about Nomura’s balance sheet

The risks of off-balance sheet financing remain largely hidden from view

A recurring subplot in many blow-ups has been the use of off-balance-sheet financing. Lehman Brothers employed the now infamous ‘Repo 105’ accounting trick to hide its true leverage. MF Global used ‘repos-to-maturity’ to the same end, while Enron deployed its special-purpose entities. 

So, when a reliable source pointed to unusually high levels of off-balance sheet financing at a Japanese investment bank, Risk.net decided to take a closer look. 

Nomura’s financial statements since 2017 show more securities collateral received than balance sheet assets, as was the case with Lehman prior to its collapse. The vast majority of these securities – around 80% in 2019 – were re-pledged or sold on in other transactions, without being recorded on the balance sheet. No other major international bank has reported more collateral received than total assets since the 2008 financial crisis.  

That might look fishy, but it doesn’t have to be dangerous. Off-balance sheet financing can be perfectly legitimate and pose little risk to an institution or the wider financial system. In Nomura’s case, there are some mundane justifications for the bank’s outlier status: as a pure-play investment bank, it is more heavily reliant on wholesale funding than rivals that have deposit-taking businesses. Accounting standards in Japan are also more conducive to netting. 

But Nomura declined to talk about it, so the questions will linger.

The level of risk depends partly on the nature of the collateral and counterparties involved. If the collateral is highly-rated government bonds, and the counterparties are well-capitalised institutions, then the risks are minimal. It’s another story, of course, if a bank is receiving lower-rated securities from highly leveraged hedge funds.

The Basel III capital framework takes a belt-and-braces approach to capturing these sorts of risks, with the leverage ratio acting as a backstop to risk-based capital requirements. It may not be enough: off-balance sheet activities circumvent the former, and they may not show up in risk-weighted assets either. 

“One of the reasons why repo could be dangerous is that, if a trade is overcollateralised even by a small amount, a bank can record zero risk-weighted assets,” says Benedict Roth, a former supervisor at the Bank of England. 

The architects of Basel III were alive to this problem. The liquidity coverage ratio and net stable funding ratio (NSFR) were introduced as additional safeguards, to ensure banks do not run excessive liquidity risks. The latter requires firms to maintain a minimum level of stable, long-term funding appropriate for their assets. 

The treatment of repo and securities lending in the NSFR is asymmetric – funding extended to financial firms requires stable funding, but funding obtained from other financial firms does not count as available stable funding – to deter banks from relying on other leveraged entities for funding. The ratio also distinguishes on the basis of collateral quality. High-quality government bonds require 5% stable funding, while corporate bonds and equities have a 50% stable funding requirement.

To the extent that Nomura’s off-balance sheet activities pose a liquidity risk, due to the collateral and counterparties involved, this should show up in the NSFR. But national regulators have been slow to implement this last piece of the Basel III framework. The NSFR will come into force in Europe and the US by the middle of this year. Japan delayed implementation of the ratio in April 2020 due to the Covid crisis. 

A spokesperson for the Japan Financial Services Agency says the rule could now be finalised at the end of March 2021. The nature of Nomura’s off-balance sheet activities should become clearer then.