A recurring subplot in many explosions has been the use of off-balance sheet financing. Lehman Brothers used the now infamous “Repo 105” accounting trick to hide its true leverage. MF Global used “repos-to-maturity” for the same purpose, while Enron used its special purpose vehicles.
So when a reliable source pointed out unusually high levels of off-balance sheet funding at a Japanese investment bank, Risk.net decided take a closer look.
Nomura’s financial statements have reported more security collateral received than balance sheet assets since 2017, as was the case at Lehman before the collapse. The vast majority of these securities – around 80% in 2019 – have been repledged or resold in other transactions without being recognized on the balance sheet. No other major international bank has reported more collateral received than total assets since the 2008 financial crisis.
This may look fishy, but it doesn’t have to be dangerous. Off-balance sheet financing can be perfectly legitimate and pose little risk to an institution or the entire financial system. In Nomura’s case, there are some mundane justifications for the bank’s outlier status: As a pure-play investment bank, it relies more heavily on wholesale financing than competitors that have deposit-taking businesses. Accounting standards in Japan are also more conducive to netting.
But Nomura declined to talk about it, so the questions will linger.
The level of exposure depends in part on the nature of the collateral and counterparties involved. When the collateral is highly rated government bonds and the counterparties are well capitalized institutions, the risks are minimal. The situation is different, of course, when a bank receives lower-rated securities from heavily leveraged hedge funds.
The Basel III The capital framework takes a belt-and-bracket approach to capturing this type of risk, with the leverage ratio acting as a backbone for risk-based capital requirements. That may not be enough: off-balance sheet activities bypass the former and may not show up in risk-weighted assets either.
“One of the reasons repo could be dangerous is that if a deal is overcollateralized by even a small amount, a bank can book zero risk-weighted assets,” says Benedict Roth, a former supervisor at the Bank of England.
The Basel architects III lived this problem. The liquidity coverage ratio and the net stable funding ratio (NSFR) were introduced as additional safeguards to ensure that banks do not take excessive liquidity risks. The latter requires companies to maintain a minimum level of stable, long-term funding commensurate with their assets.
The Treatment of Repo and Securities Lending Transactions in the NSFR is asymmetric – funding from financial firms requires stable funding, but funding received from other financial firms does not count as available stable funding – to discourage banks from relying on other leveraged firms for funding. The ratio also differs according to the collateral quality. High quality government bonds require 5% stable funding, while corporate bonds and equities have 50% stable funding.
To the extent that Nomura’s off-balance sheet activities pose a liquidity risk due to the collateral and counterparties involved, this should manifest itself in the NSFR. But national regulators have been slow to implement this final part of the Basel Accord III Frame. the NSFR will come into force in Europe and the US until the middle of this year. Japan late implementation of the relationship in April 2020 due to the Covid crisis.
A spokesman for the Japan Financial Services Agency says the rule could now be finalized by the end of March 2021. Then the nature of Nomura’s off-balance sheet activities should become clearer.