Fed on NSFR and Stays on QFCs

Federal
Reserve Board of Governors

Net
Stable Funding Ratio and Restrictions on Qualified Financial Contracts

Tuesday,
May 3, 2016

Key
Topics & Takeaways

    Progress Meeting
    Liquidity Standards
    : The Fed’s Michael Gibson noted the
    significant progress that the industry has made in improving liquidity risk
    management, which he attributed to regulatory requirements, supervisory oversight
    and stress testing, and improved business practices at financial firms since
    the financial crisis. He added that Fed staff estimate that nearly all covered
    firms would meet the minimum Net Stable Funding Ratio requirement if it were
    implemented today, and estimated the shortfall at approximately $40 billion.

  • Stay
    on Early Termination Rights
    : Fed Staff Felton Booker maintained
    that the proposed stay on early termination rights of qualified financial contracts
    is important to facilitate the orderly resolution of financial firms. He added
    that the rulemaking would: (i) help mitigate the risk that a foreign
    jurisdiction would not enforce the stay on early termination rights for
    cross-border transactions; (ii) help facilitate the single-point-of-entry
    resolution strategy preferred by U.S. G-SIBs; (iii) implement ISDA’s Stay
    Protocol; and (iv) improve consistency and transparency in the treatment of
    early termination rights in resolution.

Speakers

  • Janet Yellen, Chairman,
    Federal Reserve Board of Governors

Opening Remarks

Janet Yellen, Chairman

In
her remarks, Yellen explained that the proposed rule on the Net Stable Funding
Ratio (NSFR) is important to ensure that covered financial institutions
maintain “strong and stable” sources of funding to support the economy. 
She added that reducing the reliance on wholesale, short-term funding would help
reduce the probability that financial institutions might fail, thereby making
the financial system more resilient to market stress. Accordingly, Yellen
stated that the NSFR will require large banking organizations to maintain a
minimum amount of stable funding tailored to the risk profile of firms over a
one-year horizon.

Yellen
added that the second proposal would help reduce the potential systemic impact
of the failure of one large financial institution by imposing a limited stay on
early termination rights for qualified financial contracts (QFCs) once a firm
enters resolution.  She explained that a run on a failing bank may spur
cancellations of derivatives and repurchase (repo) contracts en masse, which
would have a destabilizing effect and make orderly resolution far more
difficult to achieve. Yellen explained that the proposal would require large
banking organizations to impose staying provisions in QFCs to allow resolution
authorities time to transfer QFCs from a failing to a stable firm.

Notice of Proposed Rulemaking on the Net Stable Funding Ratio

Daniel Tarullo, Board Member

Tarullo
recalled that the financial crisis was in the first instance a liquidity
crisis, which he said underscored the need for a quantitative liquidity risk
management standard.  Tarullo explained that the proposed NSFR would
complement the short-term Liquidity Coverage Ratio (LCR) by requiring covered
financial institutions to maintain stable funding over a one-year time horizon.

Michael Gibson,
Banking Supervision and Regulation

Gibson
contended that the proposed NSFR is another important and significant step
forward in the Dodd-Frank rulemakings, and that the quantitative requirement
would augment other aspects of the Fed’s liquidity framework, including the
stress testing regime and Comprehensive Liquidity Analysis and Review (CLAR).
Gibson noted the significant progress that the industry has made in improving
liquidity risk management, which he attributed to regulatory requirements,
supervisory oversight and stress testing, and improved business practices at
financial firms since the financial crisis. He added that Fed staff estimate
that nearly all covered firms would meet the minimum NSFR requirement if it
were implemented today, and estimated the shortfall at approximately $40
billion.

Adam Trost, Banking Supervision and
Regulation

Trost
reiterated that the NSFR is a structural balance sheet metric that requires
firms to maintain a stable funding profile over a one-year time horizon. He
explained that the proposal would also address the risk of trapped liquidity
within a consolidated firm (i.e. whereby liquidity cannot be transferred within
a consolidated firm due to transfer restrictions). Trost indicated that Fed
staff intend to prepare a separate proposal to apply the NSFR and LCR to
foreign banking organizations with significant U.S. operations. Further, to
promote market discipline, Trost stated that the proposal would require a
holding company to publicly disclose its NSFR in a standardized format on a
quarterly basis.

Question and Answer

Derivatives
and Matched Book Transactions

Yellen
asked how the proposal aims to address sources of liquidity risks emanating
from derivatives and matched book transactions. Staff explained that there is a
separate framework for addressing risks that stem from derivatives transactions
due to their complexity, including based on: (i) the aggregate current value of
a firm’s derivatives portfolio; (ii) collateral and future payments in a
derivatives portfolio; and (iii) initial margin posted based on a firm’s
derivatives transactions and default fund contributions to central
counterparties.  The staff expressed interest in receiving public comments
on whether they captured all of the risks in complex derivatives transactions,
as well as whether they are calibrated appropriately. Mark
Van Der Weide
, Division of Banking Supervision and Regulation, added that
the NSFR imposes a 10-15 percent stable funding charge to matched book repo
transactions to deal with funding and financial stability risks, and added that
the staff seek comment on whether that approach is appropriately balanced.

Interaction
with Other Liquidity Requirements

Brainard asked how the NSFR would interact with other
liquidity requirements and supervisory practices, and Van Der Weide explained
that it allows better comparability across firms to assess their funding
stability.

Vote

The
Fed Board unanimously approved publishing for comment the notice of proposed
rulemaking (NPR) on the NSFR.

NPR on Qualified Financial Contracts

Daniel
Tarullo, Board Member

Tarullo
explained that the second NPR would improve resolvability of financial firms by
imposing restrictions on QFCs that are exempt from the automatic stay
provisions in the bankruptcy framework. He maintained that financial firms are
subject to an “immediate and potentially destabilizing” unwinding of
derivatives and repo transactions, which can lead to the loss of important
funding sources and fire-sales. Tarullo recalled that the International Swaps
and Derivatives Association (ISDA) and other market participants have helped
address this barrier to orderly resolution by developing a protocol for a range
of financial contracts utilized by global systemically important banks
(G-SIBs); and he noted that eight U.S. G-SIBs voluntarily adhered to this
protocol. Yet Tarullo explained that this rulemaking would extend this stay
protocol beyond transactions among banks to transactions with all G-SIB
counterparties.

Michael
Gibson, Banking Supervision and Regulation

Gibson
explained that the QFCs include derivatives, repos and securities financing transactions
(SFTs) to mitigate threats to the orderly resolution of a G-SIB.

Felton Booker, Banking Supervision
& Regulation

Booker
maintained that the proposed stay on early termination rights of QFCs is
important to facilitate the orderly resolution of financial firms. He added
that the rulemaking would: (i) help mitigate the risk that a foreign
jurisdiction would not enforce the stay on early termination rights for
cross-border transactions; (ii) help facilitate the single-point-of-entry
resolution strategy preferred by U.S. G-SIBs; (iii) implement ISDA’s Stay
Protocol; and (iv) improve consistency and transparency in the treatment of
early termination rights in resolution.

Mark Savignac, Banking Supervision &
Regulation

Savignac
explained that the proposal would yield substantial financial stability
benefits to the U.S. by preventing disorderly resolution. He acknowledged that
firms would incur costs to comply with the rule in terms of revising
contractual provisions, as well as having to offer better terms to
counterparties to compensate them for the loss of contractual rights. However,
Savignac maintained that the benefits in terms of a reduced likelihood of G-SIB
failure as a result of this rule would outweigh these costs. 

Question and Answer

Scope
of Rule

In
response to Yellen’s question about the potential substantial migration of
counterparties away from G-SIBs to avoid being subject to this rule, Van Der
Weide explained that the proposed rule applies only to G-SIBs because they
“pose the greatest threat to financial stability if they were to fail.” 
He indicated that migration will be “relatively small” and that moving
derivatives transactions from systemically important firms to less systemically
important firms would offer a financial stability benefit.

Definition
of QFC

In
response to Fischer’s question, Booker explained that the
definition of QFC in the proposed rule is aligned with that provided in Title
II of the Dodd-Frank Act, so it should not introduce any market confusion as to
the intended scope of transactions affected by the rule.

Transition
Provision

Tarullo
noted that the transition provision would not require existing QFCs to be
revised, but would require QFCs with a particular counterparty to be revised
before a new QFC was entered into. Van Der Weide explained that the conformance
period intends to allow counterparties some flexibility to opt out of the
regime and switch to doing business with a non-GSIB if they so desire.

Vote

The
Fed Board unanimously agreed to issue the notice of proposed rulemaking on
restrictions on QFCs.

Additional
information about this event can be accessed here.