Next week on October 20^th,  the federal banking agencies will publish the finalized Net Stable Funding Ratio (NSFR) rule.  The rule, proposed in 2016, remained one of the last outstanding pieces of the Basel Committee’s post-crisis reform agenda. The NSFR is intended to ensure that banking entities maintained a structurally stable, long-term liquidity and funding profile – a complement to the shorter-term Liquidity Coverage Ratio (LCR) requirement already in place in the United States. Nevertheless, lessons learned from recent episodes of market turmoil, such as the repo event in the fall of 2019 and the COVID-19 dislocation in the spring of 2020, suggest that had the NSFR been implemented as proposed, it would not have promoted financial stability but rather would have exacerbated market stresses. Although the U.S. rulemaking will be finalized next week, it remains incumbent on the U.S. banking agencies and their international colleagues on the Basel Committee to take into account these events and adjust the NSFR’s calibration and approaches prior to implementation.

There is little question that the banking system today is safer and stronger than it was during the Great Financial Crisis (GFC).  Regulatory and stressed capital requirements have led to a two-fold increase in the amount of common equity tier 1 capital (CET1) in the banking system. The overall going- and gone-concern capital in the system has been bolstered by a panoply of requirements ranging from Global Systemically Important Bank (GSIB) capital surcharges to Total Loss Absorbing Capacity (TLAC) requirements. Similarly, banking entities have much more robust liquidity profiles today, thanks to the LCR and Regulation YY stressed liquidity requirements. In total, capital stands at more than twice its pre-GFC levels and liquidity is more than three times its pre-GFC levels.  Other changes, such as those reducing the complexity of the derivatives markets, simplifying the holding company corporate structure, and vastly improved risk management and stress testing have also made the financial system far safer.

However, the post-GFC regulatory reforms have not been unmitigated successes. There is some evidence to suggest that they have undermined liquidity provision in the financial system and have acted in a procyclical manner, amplifying market stresses rather than dampening them. This mixed record can be attributed, at least in part, to the fact that the reforms were designed to mitigate stress events that originated in the banking system. Regulators constructed policy on the assumption that a crisis would always be characterized by deposit and funding runs, market illiquidity and sizeable credit and market losses.

However, that assumption proved to be flawed during the onset of the COVID-19 crisis. In this case, the triggering stress event was external to the banking system. Instead of the deposit runs typical of the GFC, banks were now flooded with customer deposits. Additionally, banks were called on to provide credit to all sectors of the economy and to administer the U.S. government’s COVID-19 emergency programs. Moreover, banks served as critical liquidity conduits during the crisis, actively participating in the capital markets by purchasing assets and providing short-term collateralized financing . These efforts to support the flow of credit, market liquidity and to minimize the financial system’s dislocation resulted in banks’ ballooning balance sheets.

As a result, banks began to run-up against their regulatory capital constraints, attenuating their ability to intermediate on behalf of clients and provide liquidity capacity to the markets. This led regulators to issue some regulatory capital relief measures to provide banks additional balance sheet capacity to continue to intermediate government programs and actively provide liquidity to the capital markets , a sign that these requirements had not worked to mitigate stress but rather had acted in a procyclical manner to compound such stresses.

Similarly, regulations regarding banks’ funding and liquidity such as the LCR did not “protect” banks during these periods, but rather imposed unnecessary frictions through punitive calibration assumptions that impeded the efficiency of the capital markets. Had the NSFR been in force it would have compounded these problems. For example, the U.S. NSFR proposal does not recognize the substitutability of U.S. Treasuries and cash, an odd decision given that such substitutability has been a long-standing tenant of U.S. banking policy. This onerous calibration reduces market efficiencies and is akin to applying  a tax on U.S. Treasury based transactions. It  imposes unwarranted costs on banks’ U.S. Treasury inventory, reduces the effectiveness of the use of U.S. Treasuries to meet variation margin requirements and creates  negative asymmetries in the U.S. Treasury repo market . All three of these examples represent material facets of the U.S. Treasury markets and the use of U.S. Treasuries across the global capital markets. The proposed NSFR would also apply punitive assumptions regarding operational and brokered deposits and retail brokerage payables which ignores their evidenced durability across stress and benign periods.

We believe it is critical that the U.S. banking agencies, ideally in collaboration with their Basel Committee counterparts, revisit these key elements of the NSFR in order to ensure that it does not inadvertently amplify market stresses or negatively impact market efficiencies under normal market conditions.

It is also vital to consider how the NSFR would interact with other regulatory and supervisory requirements. Many of the post-crisis reforms were developed in a siloed fashion, leading  to overlapping requirements designed to mitigate the same risks. Many of these already achieve what the NSFR is intended to do: promote durable and stable funding and liquidity.

Consider the following inventory of regulatory and supervisory requirements that impact funding and liquidity:

• The LCR promotes short term liquidity resilience including by penalizing short term funding;
• Regulation YY mandates internal liquidity stress testing, relying on assumptions under stress that are more draconian than those employed in the LCR;
• The U.S. method 2 G-SIB capital surcharge, which is reliant on short term wholesale funding as a factor to increase the amount of the surcharge;
• The U.S. TLAC requirement, which mandates that US G-SIBs maintain a minimum level of unsecured long term debt with conversion features to be employed in the event of resolution;
• And liquidity and capital requirements embedded into the resolution planning process, which compel firms to pre-position capital and liquidity a subsidiary level to ensure a frictionless resolution of that entity.

We urge both the U.S. agencies and the Basel Committee to re-evaluate the NSFR to ensure that its core objectives are attained considering this existing body of regulatory and supervisory requirements. This holistic assessment is vital to ensure that the NSFR does what it was intended to do and does not inadvertently undermine market stability and liquidity during periods of stress.

Coryann Stefansson is Managing Director and Head of Prudential Capital & Liquidity Policy at SIFMA.