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«Dawood Ashraf1ƾ, Barbara L'Huillier2, Muhammad Suhail Rizwan3 1 Islamic Research & Training Institute (A member of Islamic Development Bank Group), ...»

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Does the implementation of a Net Stable Funding Ratio enhance the financial stability of the banking

industry? An international study

Dawood Ashraf1ƾ, Barbara L'Huillier2, Muhammad Suhail Rizwan3


Islamic Research & Training Institute (A member of Islamic Development Bank Group),

Jeddah, Kingdom of Saudi Arabia. dashraf@isdb.org


Associate Chair – Department of Accounting and Finance, College of Business Administration,

Prince Mohammad Bin Fahd University, Al Khobar 31952, Kingdom of Saudi Arabia blhuillier@pmu.edu.sa 3 NUST Business School, National University of Sciences and Technology, Islamabad, Pakistan.

suhail.rizwan@nbs.nust.edu.pk Abstract During the recent financial crisis (2007-2009) banks suffered huge financial and reputational consequences as a result of excessive risk taking, complicated securitization, and an asset- liability mismatch. To address this situation the Basel Committee on Banking Supervision (BCBS) introduced an updated capital regulatory framework called Basel III which included the requirement for banks to maintain a Net Stable Funding Ratio (NSFR). This paper investigates the effectiveness of Basel III by linking the NSFR with overall financial stability. After analyzing annual financial data from 948 banks from 85 countries we found convincing evidence to suggest that NSFR does increase the financial stability of banks.

Key Words: Basel III, Net Stable Funding Ratio, Finance Stability, Illiquidity.


1. Introduction As noted by Schooner and Taylor (2010) the banking industry provides long-term lending products while simultaneously guaranteeing the liquidity of their liabilities to short-term depositors. However, the recent global financial crisis (2007-2009) saw banks exposed in terms of their funding instability and illiquidity due to the maturity mismatch of assets and liabilities.

Banks and other financial intermediaries experienced this situation because they incurred major losses on investments in the US sub-prime mortgage market with the most vulnerable banks requiring State support for survival. Indeed the situation was so dire that a fundamental reassessment of the banking industry and its existing regulatory framework was conducted (Rosenthal, 2011).

In December 2010, the Basel Committee on Banking Supervision (BCBS) announced a package of new regulations under the Basel III accord to address the illiquidity and funding instability issues revealed during the 2007-2009 global financial crisis. Two of the new regulatory requirements were for banks to meet a pre-determined Liquidity Coverage Ratio (LCR) and a Net Stable Funding Ratio (NSFR). The LCR is designed to ensure that banks maintain sufficient liquidity to survive for at least thirty days under stress conditions while the NSFR is designed to avoid the maturity mismatch of assets and liabilities in order to promote a more stable funding environment in the long run.

The introduction of these new regulatory requirements by the BCBS provides a new area of research both for academic and industry researchers. Studies already conducted on the implications of Basel III include: the relationship between capital stability, risk taking behavior

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interest margins (King, 2013), and a cost-benefit analysis of the Basel III accord (Dietrich, Hess & Wanzenried, 2014; Yan, Hall & Turner, 2012). However, the impact of Basel III on the financial stability of banks from less sophisticated banking sectors is unexplored. Banks from many less developed countries have limited access to sophisticated financial risk-management tools such as financial derivatives and may rely on traditional risk-management tools for fund management. This paper attempts to fill this gap by providing empirical evidence from a sample of banks after excluding banks from North America and Europe.

Banks are multi-product, multi-factor, profit-maximizing economic units in which decisions concerning output, pricing and the use of inputs are taken simultaneously (Graddy & Kyle, 1979;

Ashraf & Goddard, 2012). In this study, the relationship between the required level of financial stability and the maintenance of a sufficient funding reserve is examined in a two-step generalized method of moments (GMM) model. This model allows for simultaneous adjustment of NSFR and stability.

By using a sample of 948 banks from 85 countries (excluding banks from North America and Europe) from 2003 to 2013, we found a positive and statistically significant relationship between the NSFR and Z-score as a proxy for financial stability of banks. Among other bank-specific covariates that contributed positively to the financial stability of banks are the regulatory capital ratio and operating profit. Interestingly, we did not find any impact of engagement in nontraditional banking activities or in higher impairment charges on the stability of banks.

However, we did find statistically significant evidence that inflation and higher concentration

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the implementation of the Basel III accord.

This paper provides empirical evidence on the association between the NSFR measures introduced in the Basel III accord and the financial stability of the banking sector. Secondly, banks from less developed financial markets usually have less access to income sources outside traditional intermediation activities therefore the NSFR requirements may have stronger implications for these banks. To the best of the authors’ knowledge there is no published study that has explored the financial implications of Basel III on banks from less developed markets.

This empirical work fills this gap by using data from less sophisticated banks from outside the North American or European banking sectors 1. This study uses data from pre and post crisis time periods thereby providing a stress test scenario for Basel III.

The organization of the paper is as follows. Section two provides a review of the existing literature that surrounds the new BASEL III accord and the null hypothesis that is the basis of this study. Section three provides an explanation of the suggested impact that the new NSFR requirements will have on the financial stability of the banking industry. Section four provides a detailed description of the variables that affect our analysis of the new NSFR requirements including stability measures, bank-specific and country-specific variables. Section five describes the sample used for this study, the sources of data used, and their analysis. Section six details the empirical methodology that underpins and supports this study followed by a discussion of the results of this study. The final section summarizes the key findings of this study and provides concluding comments.

1 See Yan et al., (2012) and Dietrich et al., (2014).

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The BCBS proposed the first capital accord, referred to as Basel I, in 1988. The major focus of the Basel I accord was to adequately capitalize international banks against credit risk. The accord set a required 'minimum' percentage of risk-weighted assets to total bank capital (Santos, 2001). The accord was revised in 1997 to incorporate market risk such as interest rate and foreign exchange risk in the calculation of risk-weighted assets and capital requirements.

In 2004 the BCBS introducing a new capital accord, known as Basel II, to help protect the banking system against a wider range of risks and in response to the increased pace of financial innovations sweeping the banking industry worldwide. The calculation of minimum capital requirements were now to be structured around three pillars: credit risk, market risk and operational risk. Banks were given more autonomy for the assignment of risk-weighting to assets based on expert systems. Unfortunately the Basel II accord did not prevent nor provide a warning of the impending global 2007-2009 financial crisis.

One of the major criticisms of the Basel II accord was its narrow focus on bank-level stability through micro-prudential regulations and was not designed to address systemic issues. This situation gave rise to the ‘too-big-to-fail’ phenomena arising from a moral hazard problem in the banking industry (Schwerter, 2011). Indeed as research by Ashraf and Goddard (2012) reveals, the financial innovations intended to transfer risk from the banking sector to a wider set of investors through capital markets led to the liquidity crunch within the global financial system.

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resulted in a need to reassess the existing banking regulatory framework. This reassessment revealed severe shortcomings in the regulatory framework of the banking industry and resulted in a new framework being introduced. This new framework is known as the Basel III accord.

Several new measures are introduced in the Basel III accord in an effort to avoid a repeat of the liquidity crisis of 2007-2009 (Pakravan, 2014). One of the most important measures to be introduced was the requirements of a NSFR whereby banks are required to maintain sufficient liquid funds should a situation similar to the financial crisis of 2007-2009 arise.

Proponents of Basel III, such as Yan et al., (2012), claim that the adoption of the new regulatory framework helps enhance better risk-management by reducing the frequency of crisis’s (loss prevention) and thus decreases economic losses. Likewise, Schwerter (2011) argues that the Basel III accord provides for more effective regulations to achieve the goal of guiding financial institutions (specifically) and the financial system (generally) towards greater stability. Allen et al., (2012) suggests that the adoption of Basel III is a major structural shift in the risk management practices of the banking industry and has the potential to transform business models, processes and governance of international banks.

But the Basel III accord is not without its critics. Admati et al., (2011) claims that the adoption of Basel III will limit credit availability and thus reduce economic activity. Allen et al., (2012) concurs suggesting that the requirements under the Basel III accord results in structural adjustments that might affect the supply of credit in the economy. Pakravan (2014) suggests that

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parameters of riskiness and as such will make it vulnerable to regulatory arbitrage. He further argued that the Basel III accord is a sequel to the two previous accords with similar expected results of not being able to alert regulators before the onset of a major crisis.

In the empirical literature Distinguin et al., (2013) explored the possible linkage between regulatory capital adjustments in response to liquidity constraints by using a sample of 781 US and European banks from 2000 to 2006. They found that U.S. and European banks tend to decrease their regulatory capital ratio when faced with higher illiquidity as defined in the Basel III accord. Similarly, Hong et al., (2014) investigated the impact of liquidity risk measures using the NSFR and liquidity coverage ratios with bank failure using a hazard model on quarterly panel data extracted from the call report data of US banks for the period 2001 to 2011. Their empirical findings suggest that liquidity risk is a predictor of bank failure and to avoid such failures liquidity risk should be minimized not just on an individual bank level but at a system level as well. These findings support new liquidity requirements under the Basel III accord through which banks are now required to maintain and improve their solvency (NSFR) during periods of higher illiquidity.

Yan et al., (2012) investigated the impact of tighter capital regulations and liquidity requirements under the Basel III accord on a sample of 11 UK banks for the period 1997 to 2010. They found that higher regulatory capital requirements not only reduces the probability of a banking crisis but also reduces the economic loss from a banking crisis.

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on earning ability of banks by using a sample of banks from 15 countries. He found that banks from 10 out of the 15 countries could not meet the minimum NSFR requirements at the end of year 2009. He suggested that a possible response from the banking sector may include shrinkage of the balance sheet, change in the composition of assets (loans or investments) or their maturity with each option having a cost to the wider economy. Jiraporn et al., (2014) studied the relationship between the NSFR and risk-taking behavior of banks by using a sample of 68 banks from 11 East Asian countries for the period 2005-2009. They found an inverse relationship between the intensity of capital regulation and risk-taking by banks using Z-score as a proxy for risk-taking. More precisely they report that an enhancement in capital stability by one standard deviation diminishes risk-taking by 5.37%.

While the empirical literature on developed markets highlight the general benefits of the new regulatory ratio of net stable funding for risk-management the impact of the new NSFR on the financial stability of banks from outside the North American or European banking sectors is unknown. Banks from the omitted regions can be quite different from that of North American and European domiciled banks. These banks may have less access to sophisticated financial risk-management tools such as financial derivatives and may rely on traditional asset-liability matching for fund management. To take this into account our null hypothesis for this study is as


H0: the NSFR requirements in the Basel III accord will have no impact on the financial

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or benefit of the NSFR on the stability of banks. In the following section we develop the covariates for the empirical estimations.

3. The impact of the NSFR on financial stability The existing empirical literature has generally focused on developed markets with the resulting research findings highlighting the general benefits of the new regulatory requirements for riskmanagement implying that the NSFR does helps encourage stability in the banking sector.

However, it should be noted that financially stable banks tend to maintain higher funding levels in order to manage a bank-run situation. Furthermore, maintenance of desired stability levels and target NSFR’s are not independent decisions.

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