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year and imposes that the resources that regulators see as non-volatile over one year be at least equal to the amount of assets that are seen to stay in place under the same horizon.

      The ratio is implemented by comparing the available stable funds (ASF) to the required stable funds (RSF). The stable funds are the financing that is expected to stay in place for an extended period of at least one year, excluding any volatile debt. The required stable funds represent the amount of assets that supervisors believe should be supported with stable funding.

      According to the NSFR, the ratio of ASF to RSF should be above one. For measuring required and available stable funds, percentages called factors, are used for weighting assets and liabilities. The RSF are derived from assets, by applying RSF factors to existing assets.

      The RSF factors measure how easy it is to turn assets into cash. They range from 0 %, for those assets that do not require stable funding, to 100 % for those assets that should be supported entirely by long-term funds. Good quality market instruments, such as investment grade bonds, do not require 100 % of stable funds because they can be sold or financed by pledging them for borrowing. On the other hand, some loans with maturity longer than one year would require close to 100 % stable funding.

      The ASF factors measure how stable the resources are and are in the range of 0 to 100 %. Factors in the upper range are applied to stable resources, such as equity and bonds issued by the bank. Factors in the lower range are used for resources that are considered as less stable, or volatile, such as the fluctuating fraction of deposits and short-term interbank debt.

3.1.4 The Leverage Ratio

      The leverage ratio is intended to prevent the excessive buildup of exposures during expansion period. Banks can build up leverage in expansion, even when they maintain a strong capital base. The purpose of the ratio is to limit the expansion of the balance sheet in growth periods, and, consequently, limit the deleveraging of the balance sheet under recession periods.10

      The leverage ratio imposes that core capital be at least 3 % of the balance sheet size, plus some off-balance sheet commitments such as uncancellable banking commitments. The ratio is implemented over a test period extending until 2017.

      3.2 Compliance of a Commercial Balance Sheet: Example

      The combination of the capital adequacy ratio, the LCR, the NSFR and the leverage ratio results in four constraints on the balance sheet of a bank. An example of a typical balance sheet is used below to show how compliance can potentially reshape a typical balance sheet and impact the profitability of a bank.

      The combination of four ratios makes the management of the balance sheet a constrained exercise. The mix of assets and liabilities of the banking book is business driven. In a typical commercial bank, the bank holds corporate loans and loans to individuals arising from consumer lending and mortgage loans, plus an investment portfolio made of financial assets managed under a buy and hold policy. On the liabilities side, commercial resources are the deposits.

      Assuming that the mix of commercial loans and deposits is given, the bank should manage its portfolio of liquid assets and its financing in order to comply with regulatory constraints.

      The following example relies on a simplified balance sheet of a hypothetical commercial bank (Table 3.1). The commercial activities include mortgages plus corporate and retail loans. The bank also has an investment portfolio, which is assumed to be made of investment-grade bonds. On the resource side, the bank has long-term resources combining capital and subordinated debt, plus bonds issued in the capital markets. The bank's main resources are retail deposits and wholesale debt. The purpose of the example is to determine whether the initial balance sheet is Basel 3 compliant and what are the required changes to make it compliant.

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      1

      Knight, F. H. (1921), Risk, Uncertainty and Profit, New York.

      2

      The definition is from the Basel 2 document (2006), [21].

      3

      The fund transfer pricing system is addressed in Chapter 10 the risk allocation issue is discussed in Chapter 27 and risk-adjusted performance is discussed in Chapters 10 and

1

Knight, F. H. (1921), Risk, Uncertainty and Profit, New York.

2

The definition is from the Basel 2 document (2006), [21].

3

The fund transfer pricing system is addressed in Chapter 10 the risk allocation issue is discussed in Chapter 27 and risk-adjusted performance is discussed in Chapters 10 and 28.

4

Basel Committee on Banking Supervision (1988), International convergence of capital measurement and capital standards, [17].

5

There are numerous papers on the liquidity crunch of 2008. See, for example, Brunnermeier, M. K. (2009), Deciphering the liquidity and credit crunch 2007–2008, [39], and Brunnermeier, M. K., Pedersen, L. H. (2009), Market liquidity and funding liquidity, [40].

6

See, for example, Laux, C., Leuz, C. (2010), Did fair-value accounting contribute to the financial crisis?, [89].

7

On so-called “liquidity spirals”, see Brunnermeier, M. K. (2009), Deciphering the liquidity and credit crunch 2007–2008, [39].

8

See Longstaff, F. A. (2010), The subprime credit crisis and contagion in financial markets, [94].

9

See “Addressing systemic risk and interconnectedness”, paragraph 32 of the 2010 Basel 3 document [24]. Systemic risk is addressed in the literature: see Arnold, B., Borio, C., Ellis, L., Moshirian, F. (2012), Systemic risk, macroprudential policy frameworks, monitoring financial systems and the evolution of capital adequacy [14]; or Nijskens, R., Wagner, W. (2011), Credit risk transfer activities and systemic risk: How banks became less risky individually but posed greater risks to the financial system at the same time [111].

10

Sources on leverage and liquidity include Acharya, V. V., Viswanathan, S. (2011), Leverage, moral hazard, and liquidity, [2], and Adrian, T., Shin, H-S. (2010), Liquidity and leverage, [4].