Understand the new features of monetary policy- What is Counter Cyclical Buffer, Liquidity Coverage ratio and Net Stable Funding Ratio?

Recent monetary policy came up with three major provisions under BASEL III that are to be implemented by the banks of Nepal. These three provisions are Counter cyclical buffer, Liquidity Coverage Ratio and Net Stable Funding Ratio.

During the financial crisis of 2007-2008, the over reliance on short term wholesale funding from interbank lending market caused banks such as UK’s Northern Rock and US investment banks Bear Stears and Lehman Brothers to suffer a liquidity crisis. As a result, BASEL III introduced these three components to limit the reliance of banks on short term unstable funding.

Counter cyclical buffer:

Banks, in general, share a same customer segment. The sources of avenues for credit distribution and deposit collection are almost similar in every bank. In a country like Nepal, where majority of the population is concentrated in the cities and branches of banks can be found in every lane in the cities, the competition becomes stronger. The constant fluctuation of interest rates of banks can be justified by this competition over a common customer segment.

The liquidity crunch (situation when the demand of loan is high but number of avenues to fund loan is few) has been major problem in the banking economy. During higher liquidity, banks disperse funds in the form of loans easily. However, during liquidity crunch, banks are selective to provide loans. The nature of banking economy is pro cyclical in the nation. This means that the rise and decline in financing from bank is proportional to growth and decline of economy. In reality, the importance of a bank is significant when the economy is in decline. However, usually, in such periods banks do not involve in aggressive credit dispersion.

Counter cyclical buffer, therefore, aims to allocate a certain amount of fund aside in the boom period in order to use it in the period of crisis. For instance, during the good times, CCCB encourages banks to create buffer of capital by setting a certain fund aside for the bad times. Besides, CCCB also assures banks are not engaged in indiscriminate credit lending during the good times. However, requirement of Counter Cyclical Capital Buffer should be notified by the central bank at least four quarters earlier than the actual crisis in order for the banks to make necessary preparations. In India, RBI (Reserve Bank of India) introduced the policy of counter cyclical buffer in February, 2015. However, the implementation of this policy was postponed a year by Indian government as most of the Indian banks were not ready to handle the burden of CCCB.

The Counter Cyclical Buffer needs to be implemented in the following framework:

If the provided framework is not implemented until Asadh end 2077 then Banks will not be able to provide cash dividend. The capital adequacy ratio should also be 13% above in order to distribute dividend. Previously banks could maintain 11% CAR to distribute dividend.

Liquidity Coverage ratio:

Liquidity Coverage Ratio (LCR) prepares banks for short term resilience at times of severe liquidity stress scenario. The purpose of LCR is to ensure banks maintain an adequate level of High Quality Liquid Assets (HQLA) which can be converted into cash to meet its liquidity needs that can last for a time horizon of 30 calendar days. LCR is calculated by dividing HQLA by Total net cash outflows over the next 30 days. The net cash outflow is calculated by subtracting the total outflows from total inflows under a stressed situation as per BASEL III guidelines. This will strengthen banks’ ability to absorb shock that arises from several financial and economic stresses. After the implementation of LCR, banks need to hold a specified amount Highly liquid assets which will be able to fund the banks’ outflows for 30 days. LCR will act as a cushion against the event of financial crisis.

Net Stable Funding Ratio:

Just as LCR promotes resilience of banks for a shorter period of time, Net Stable Funding Ratio does the same for a longer horizon of time. The purpose of NSFR is to ensure banks have enough incentives to fund daily based activities with a stable source of funding. During good economic times, banks rely on short term investment and sources of funding which is usually trouble for banking operation. So, in order to limit this, NSFR ensures banks maintain stable funding structure. It can be calculated by dividing Total Available Stable Funding by Total Required Stable Funding. Sources of Available Stable funding includes: customer deposits, long-term wholesale funding (from the interbank lending market)and equity.

NRB has implemented BASEL III partially. In the days to come, these features are expected to help banking economy attain a better liquidity position in the baking arena.