120% rule drained deposits and halted reliance on outside risk

A national banking regulator introduced a 120% funding requirement this year after a period of market strain. Under the rule banks must cover specified counterparty exposures and third-party collateral lines with eligible on-balance funding equal to at least 120% of the exposure. The rule disallows counting some external guarantees and accepted market practices as sufficient coverage and immediately increased banks’ measured liabilities and the cost of short-term market funding.

Banks shifted existing customer deposits to cover new funding needs. Depositors faced lower advertised yields and tighter withdrawal conditions on some accounts and moved funds into government-backed accounts and private short-term funds not subject to the same on-balance treatment. Several mid-sized and regional lenders reported declines in core deposits after institutional clients reclaimed liquidity or moved balances to custodial arrangements outside the banking system.

Lenders reduced activity that depended on third-party risk assumptions. Transactions that previously relied on external credit opinions, rating-agency scores or counterparty collateral practices now face requirements for more direct collateral, higher haircuts or on-balance-sheet capital backing. Bank credit committees rejected deals that relied heavily on counterparties’ risk models. Originations of asset-backed securities and repurchase agreements fell in the months after the rule’s announcement because the required over-collateralization made many trades uneconomic.

A senior bank executive commented, “We can’t rely on another firm’s risk calculus and assume that collateral will be treated the same way by regulators. We are bringing more activity onto our balance sheets and asking for more cash collateral up front.” The executive described fewer funding options and greater demand for cash collateral on trading desks.

A regulator involved in drafting the rule noted the aim was to prevent losses from being shifted through chains of contracts and to ensure banks hold funding that reflects actual exposure. The regulator added that the 120% threshold was chosen to create an additional buffer against valuation swings in stressed markets.

The change reduced the deposit balances banks treat as stable funding. Some institutional balances were reclassified or withdrawn when counterparties reorganized custody arrangements to avoid having assets counted as bank funding. Banks reported a contraction in deposits they consider usable to fund loans and operations, and some lenders slowed lending growth and raised rates on new loans.

Trading desks reported a drop in repo and securities lending activity. Desks that had relied on posting and re-using collateral faced higher upfront demands or had to post cash instead of eligible securities, increasing the cost of short-term liquidity for institutions that depend on those channels.

Industry groups warned the rule would raise funding costs for smaller banks and could reduce credit availability for medium-sized firms that relied on quicker, market-based funding. Some banks increased holdings of central bank reserves and government debt to meet the new collateral metrics, while others rebuilt internal risk models, lengthened approval processes and tightened loan covenants to reflect the on-balance funding requirement.

Regulators described the requirement as an attempt to align recorded exposure with funding responsibility and to close gaps that allowed leverage outside traditional bank capital measures. Background to the policy includes recent episodes in which chains of collateral reuse and reliance on external risk signals amplified market strains, prompting the regulator to require a larger internal buffer around certain exposures.