New rules on commercial banks’ foreign currency funding ratios

New rules on commercial banks’ foreign currency funding ratios

The Central Bank of Iceland has adopted new rules on commercial banks’ foreign currency funding ratios. The funding ratio is intended to ensure a minimum level of stable one-year funding in foreign currencies and therefore restrict the degree to which the commercial banks can rely on unstable short-term funding to finance long-term foreign-denominated lending. The rules on funding ratios reduce maturity mismatches and limit the extent to which the banks can depend on unstable short-term funding to finance long-term assets that could prove difficult to sell.

Maturity transformation between assets and liabilities is an important contribution made by the banks to the economy, but it is also risky. By transmitting liquidity to the banking system and acting as a lender of last resort, central banks can mitigate the systemic risk that accompanies this maturity transformation. A central bank’s ability to grant foreign-denominated last-resort loans is limited, however. As a result, it is undesirable that the banks should take risks based on the assumption that the Central Bank will be able to extend foreign-denominated loans to them under duress. During the prelude to the 2008 financial crisis, the large commercial banks’ maturity mismatches escalated markedly. The banks relied increasingly on short-term foreign funding, including collateralised short-term loans and foreign deposit collection, which led to rising foreign refinancing risk. Rules on stable funding such as those now being adopted should impede adverse developments such as those taking place during the run-up to the financial crisis.

In view of experience, the Central Bank considers it important to reduce the risk that could result from excessive maturity mismatches between the commercial banks’ assets and liabilities by explicitly limiting maturity mismatches in foreign currency. This is particularly important during the prelude to capital account liberalisation. The funding ratio that the Bank has now adopted is based on the Basel Committee’s rules concerning net stable funding ratios (NSFR).

The Bank intends to implement the rules on funding ratios, which are designed to cover periods ranging up to three years, in 2015. This is in accordance with the declared objectives set forth in the Bank’s publication entitled “Prudential Rules Following Capital Controls”, according to which domestic financial institutions should be able to withstand closure of foreign credit markets for up to three years.

Further information can be obtained from Már Guðmundsson, Governor of the Central Bank of Iceland, and Sigríður Benediktsdóttir, Director of the Financial Stability Department of the Central Bank, at tel: +354 569-9600.

No. 40/2014
3 December 2014