net-stable-funding-ratio

Net Stable Funding Ratio

Business / By / November 28, 2023

Net Stable Funding Ratio (NSFR) is a regulatory requirement ensuring banks maintain stable funding to mitigate liquidity risk over one year. It involves calculating Available Stable Funding (ASF) and Required Stable Funding (RSF) to meet a minimum ratio set by regulators. NSFR contributes to financial stability but poses challenges like compliance costs and complexity in implementation. It’s a key component of Basel III and widely adopted by regulatory authorities worldwide.

The Enlightened Accountant by Gennaro Cuofano – FourWeekMBADownload

What is the Net Stable Funding Ratio (NSFR)?

The Net Stable Funding Ratio (NSFR) is a regulatory requirement that measures a bank’s long-term stability of funding sources relative to the liquidity of its assets and off-balance-sheet activities. In simpler terms, it assesses whether a bank has enough stable funding to support its illiquid assets over a prolonged period, typically one year.

The NSFR is designed to mitigate the risk of bank runs and liquidity crises by ensuring that banks maintain an appropriate balance between their short-term and long-term funding sources. By doing so, it promotes greater financial stability and reduces the likelihood of institutions facing insolvency due to a sudden loss of liquidity.

Calculation of NSFR

The NSFR is calculated by dividing the available stable funding (ASF) by the required stable funding (RSF). The formula for the NSFR is as follows:

Where:

  • ASF (Available Stable Funding) represents the amount of stable funding sources that a bank has to support its illiquid assets and off-balance-sheet exposures over a one-year horizon. These stable funding sources are typically more reliable and less prone to sudden withdrawals.
  • RSF (Required Stable Funding) represents the weighted sum of a bank’s illiquid assets and off-balance-sheet exposures, each multiplied by a specific factor that reflects their liquidity risk. The RSF captures the potential outflow of funds associated with these assets and exposures.

The NSFR is expressed as a ratio, and the Basel III framework prescribes a minimum NSFR requirement of 100%. This means that a bank must have at least as much available stable funding as required stable funding to meet the regulatory standard.

Significance of NSFR

The Net Stable Funding Ratio (NSFR) holds significant importance in the realm of banking and financial regulation for several reasons:

  1. Promoting Liquidity Resilience: The NSFR is a crucial tool for promoting liquidity resilience in banks. By ensuring that institutions maintain a stable funding base, it reduces their vulnerability to sudden liquidity shocks and bank runs.
  2. Preventing Fire Sales: In times of financial stress, banks without adequate stable funding may be forced to sell illiquid assets at distressed prices to meet withdrawal demands. The NSFR helps prevent such fire sales, which can exacerbate market turmoil.
  3. Aligning Funding Structure: The regulation encourages banks to align their funding structure with the liquidity profile of their assets. This discourages excessive reliance on short-term, potentially volatile funding sources.
  4. Enhancing Financial Stability: The NSFR contributes to overall financial stability by reducing the likelihood of systemic crises. It helps create a more resilient banking system less prone to contagion effects.
  5. Meeting Regulatory Requirements: Compliance with the NSFR is a regulatory requirement for banks, and non-compliance can result in penalties and restrictions on their operations. Therefore, it is a critical aspect of banking supervision.

Factors Affecting NSFR

Several factors can influence a bank’s Net Stable Funding Ratio (NSFR). Understanding these factors is essential for banks to manage and maintain compliance with regulatory requirements. Here are some key factors that can affect NSFR:

  1. Funding Mix: The composition of a bank’s funding sources is a significant factor. Banks with a higher proportion of stable funding, such as retail deposits and long-term borrowings, are more likely to have a favorable NSFR.
  2. Asset Liquidity: The liquidity profile of a bank’s assets plays a critical role. Illiquid assets, such as long-term loans or investments, may require more stable funding to meet the NSFR requirements.
  3. Off-Balance-Sheet Exposures: Off-balance-sheet activities, such as contingent liabilities or commitments, can impact the NSFR. These exposures are subject to RSF factors that influence the required stable funding.
  4. Market Conditions: Changing market conditions, including shifts in interest rates or funding costs, can affect a bank’s NSFR. Unforeseen changes may require adjustments to funding strategies.
  5. Regulatory Changes: Amendments to regulatory standards or NSFR calculation methodologies can impact compliance. Banks must stay informed about regulatory updates and adapt their practices accordingly.

Managing and Maintaining NSFR

To manage and maintain compliance with the Net Stable Funding Ratio (NSFR) requirements, banks employ various strategies and practices:

  1. Diversified Funding Sources: Banks aim to diversify their funding sources to include a mix of stable funding, such as retail deposits and long-term debt, and less stable sources. Diversification reduces reliance on short-term funding.
  2. Asset-Liability Management (ALM): Banks engage in ALM practices to align the maturities and liquidity profiles of their assets and liabilities. This helps ensure that assets are funded adequately over time.
  3. Capital Allocation: Proper allocation of capital to support illiquid assets is essential. Banks need to allocate sufficient capital to meet regulatory requirements.
  4. Stress Testing: Stress testing exercises help banks assess their resilience to adverse scenarios and evaluate their NSFR under stressed conditions. This helps identify vulnerabilities and plan for contingencies.
  5. Regular Reporting: Banks are required to report their NSFR to regulatory authorities regularly. Accurate and timely reporting is crucial for compliance.
  6. Strategic Planning: Banks develop long-term strategic plans that consider NSFR compliance. These plans involve optimizing funding strategies and managing asset liquidity.

Conclusion

The Net Stable Funding Ratio (NSFR) is a vital component of the Basel III framework and serves as a critical tool for promoting liquidity resilience and financial stability within the banking industry. It measures a bank’s ability to fund its illiquid assets and off-balance-sheet exposures over a one-year horizon with stable sources of funding. Compliance with the NSFR is not only a regulatory requirement but also an essential element of prudent risk management for banks. By maintaining a balanced funding profile and aligning it with the liquidity of their assets, banks can enhance their stability and reduce the risk of liquidity crises, ultimately contributing to a safer and more robust financial system.

Connected Financial Concepts

Circle of Competence

circle-of-competence
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

venture-capital
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

foreign-direct-investment
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

micro-investing
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

meme-investing
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

retail-investing
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

startup-valuation
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

profit-vs-cash-flow
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

financial-modeling
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

valuation
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

financial-ratio-formulas

WACC

weighted-average-cost-of-capital
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

financial-options
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

Profitability Framework

profitability
A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.

Triple Bottom Line

triple-bottom-line
The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.

Behavioral Finance

behavioral-finance
Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.

Connected Video Lectures

Read Next: Biases, Bounded Rationality, Mandela Effect, Dunning-Kruger

Read Next: Heuristics, Biases.

Main Free Guides:

More Resources

About The Author

Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
Scroll to Top
FourWeekMBA