UK repo decline sparks NSFR tussle in Europe

BoE and EC concerned about repo liquidity, but Basel Committee unlikely to budge

European officials have asked the Basel Committee on Banking Supervision to take another look at the treatment of repos in the Net Stable Funding Ratio (NSFR), according to an industry source, who cites the European Commission and the Bank of England (BoE) as the prime movers in the initiative.

"They have said they will be looking at this and have found they are quite interested. People are more and more conscious [that] we need to look at what we are implementing. The discussions are ongoing in Basel and that is what is happening," says the industry source.

The NSFR is one of two liquidity requirements drafted by the Basel Committee, and is aimed at ensuring banks back assets with maturities of more than one year with similarly long-term funding. The requirement is calculated by dividing a bank's available stable funding (ASF), which applies to its liabilities, by its required stable funding (RSF), which applies to its assets, with a minimum ratio of 100%. Both the ASF and RSF totals are determined by applying regulator-set multipliers to assets and liabilities.

The asymmetric treatment of short-term repos in the final NSFR standards has been a key lobbying point for the industry. If banks extend repos with residual maturities of less than six months backed by sovereign bonds, there is a 10% RSF. For short-term repos backed by high-grade corporate or covered bonds, the RSF is 15%. By contrast, recipients of repo funding from other financial institutions with maturities of less than six months receive an ASF factor of 0%.

The European Repo and Collateral Council (ERCC) at the International Capital Market Association has been actively lobbying against the asymmetric treatment of repos in the NSFR. In a working paper published on March 23, the ERCC proposed that repos with a maturity of less than six months should be exempted from RSF.

"Generally speaking, NSFR is likely to depress the repo market… There are imbalances between the available stable funding and required stable funding parts of the formula that penalise banks for transacting with most counterparties including on CCPs," says Josh Galper, managing principal of repo research and consultancy firm Finadium.

Repo market decline

The industry source says this asymmetric treatment is now prompting concern at the EC and BoE as well. The Basel Committee, Bank of England and EC all declined to comment.

In May 2016, the EC published a targeted consultation on implementing the NSFR in the European Union, which explicitly asked if respondents had "substantiated evidence" about its impact on short-term interbank financing in Europe.

"If yes, what alternative treatment would you propose for NSFR calculation purposes to deal with the funding needs arising from short-term transactions with financial institutions?" the consultation requested.

The EC is currently awaiting further technical advice from the European Banking Authority before tabling a legislative proposal to implement the NSFR.

The topic was also raised during a meeting of the Bank of England's Securities Lending and Repo Committee (SLRC) on March 29, 2016. At the meeting, Sarah John, head of the BoE sterling markets division and chair of the SLRC, referred to an earlier statement by the Financial Policy Committee (FPC), which acknowledged that: "Some market developments motivate careful review and consideration of whether there are any possible refinements to internationally agreed post-crisis regulations that could further promote market effectiveness without compromising the resilience of the core of the financial system."

More recently, the July 2016 BoE financial stability report raised explicit concerns about the decline of the repo markets in the UK, with volumes for government gilt repos slipping noticeably in recent months (see chart). This could also have implications for monetary policy operations, as central bank repo activity relies on commercial banks extending the liquidity chain into the interbank market.

"The most marked changes in market conditions have been in the securities financing markets, specifically, those for repurchase agreements, or ‘repo'. The FPC judges that these developments are of sufficient importance to financial stability and market functioning to warrant further domestic and international assessment of their causes and consequences," the report warned.

Whereas Basel capital ratios have been in operation for many years, the NSFR is an entirely new concept that has been devised since the financial crisis and finalised in October 2014. As a result, there is very little historic data that can be used to estimate its potential impact on the functioning of financial markets. The Basel Committee is apparently reviewing the liquidity standards on an ongoing basis, to ensure they operate as expected and that there are no unintended consequences.

ECB bites back

The EC and BoE concerns are by no means shared by all European regulators, however. The EC has not yet issued a full list of responses to its NSFR consultation, but the European Central Bank (ECB) has already published its own submission on September 14. This argued in favour of the asymmetric treatment of repo, while dismissing industry fears about the negative impact on repo liquidity.

"The asymmetric treatment of short-dated repos and reverse repos reflects that banks, during crises, often need to roll over lending owing to franchise concerns, even as their matched funding is curtailed. Market participants have voiced concerns about the potential impact of the NSFR on repo markets. The available evidence… has so far not supported this view. Repo market volume has remained resilient despite the "frontloading" of banks' NSFR," the ECB response stated.

The European Systemic Risk Board is expected to publish a paper on bond market liquidity in the coming weeks. One continental European national regulator familiar with the study says it finds no evidence to support the claim that regulation has caused lower market liquidity. He tells Risk.net by email that the NSFR required stable funding factor for short-term government and corporate bond repo "is justified."

"[It] aims at capturing a number of risks simultaneously: price volatility of the underlying asset, liquidity risk in the repo market and the risk that haircuts increase in repo markets. In addition, the [RSF] on assets and on the related repos needs to be consistent to reduce the incentives for arbitrage," he says.

The RSF on cash holdings of government bonds is 5%, and that on high-grade corporate or covered bonds is 15%. If the RSF for repos of less than six months were cut to 0%, this means banks could avoid the NSFR on sovereign and corporate bonds by holding them as repo collateral rather than directly. In this context, the industry might at best have some justification to argue for the RSF on government bond repos to be equalised with cash government bonds at 5%, instead of the current 10%.

While panellists at the annual Liquidity and Funding Risk Conference in London last week were confident the EC will dilute NSFR rules with regard to derivatives liabilities, they were much more sceptical about the idea of the Basel Committee altering the asymmetry for repos.

"The regulators are well aware of what they are doing. The asymmetry of repo and reverse repo, they are very comfortable with it and there are reasons why," said Christopher Blake, a senior manager of liquidity risk at HSBC.