What is the 'Liquidity Coverage Ratio - LCR'
The liquidity coverage ratio (LCR) refers to highly liquid assets held by financial institutions to meet short-term obligations. The ratio is a generic stress test that aims to anticipate market-wide shocks. The liquidity coverage ratio is designed to ensure financial institutions have the necessary assets on hand to ride out short-term liquidity disruptions.
BREAKING DOWN 'Liquidity Coverage Ratio - LCR'The liquidity coverage ratio applies to all banking institutions with $10 million or more in on-balance sheet foreign exposure and subsidiary depository institutions with $10 billion or more in assets. Additionally, the ratio applies to all banking institutions with $250 billion or more in total consolidated assets. Banks are required to hold an amount of highly liquid assets, such as cash, Treasury bonds or corporate debt, equal to or greater than their net cash outflow less the projected cash inflows over a 30-day stress period, having at least 100% coverage.
The liquidity coverage ratio started to be regulated and measured in 2011, but the full 100% minimum was not enforced until 2015. The liquidity coverage ratio is an important part of the Basel Accords, as they define how much liquid assets have to be held by financial institutions. Because banks are required to hold a certain level of highly liquid assets, they are less able to lend out short-term debt.
High-Quality Liquid Asset Categories
The high-quality liquid assets include only those with a high potential to be converted easily and quickly into cash. There are three categories of high-quality liquidity assets with decreasing levels of quality: level 1, level 2A and level 2B assets.
Under Basel III, level 1 assets have no haircut, while level 2A and level 2B assets have a 15% and 50% haircut, respectively. Level 1 assets include Federal Reserve bank balances, foreign withdrawable resources, securities issued or guaranteed by specific sovereign entities and multilateral development banks, and U.S. government issued or guaranteed securities. Level 2A assets include securities issued or guaranteed by specific multilateral development banks or sovereign entities, and securities issued or guaranteed by U.S. government-sponsored enterprises. Level 2B assets include specific publicly traded common stock and investment-grade corporate debt securities issued by nonfinancial sector corporations.
Liquidity Coverage Ratio Calculation Example
The LCR is calculated by dividing a bank's stock of high-quality liquid assets by its total net cash outflows over a 30-day stress period. Assume bank ABC has stock of high-quality liquid assets worth $55 million and $35 million in anticipated net outgoing cash flows over a 30-day stress period. Therefore, bank ABC has an LCR of 1.57, or 157%, which meets the requirement under Basel III.