What is the Liquidity Coverage Ratio - LCR
The liquidity coverage ratio (LCR) refers to the proportion of highly liquid assets held by financial institutions, to ensure their ongoing ability to meet short-term obligations. This ratio is essentially a generic stress test that aims to anticipate market-wide shocks, and make sure that financial institutions possess suitable capital preservation, to ride out any short-term liquidity disruptions, that may plague the market.
Liquidity Coverage Ratio
BREAKING DOWN Liquidity Coverage Ratio - LCR
The liquidity coverage ratio applies to all banking institutions that have more than $250 billion in total consolidated assets or more than $10 billion in on-balance sheet foreign exposure. Such banks, often referred to as "Systematically Important Financial Institutions (SIFI)", are required to maintain a 100% LCR, which means holding an amount of highly liquid assets that are equal or greater than its net cash flow, over a 30-day stress period. Highly liquid assets can include cash, Treasury bonds or corporate debt.
The LCR was implemented and measured in 2011, however the full 100% minimum was not enforced until 2015. The LCR is a chief takeaway from the Basel Accord--a series of regulations developed by The Basel Committee on Banking Supervision (BCBS), which is a group of 27 representatives from major global financial centers. This bloc of individuals believed that mandating banks to hold a certain level of highly liquid assets, and maintain certain levels of fiscal solvency, would discourage them from lending high levels of short-term debt.
High-Quality Liquid Assets for the Liquidity Coverage Ratio
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 such assets, with decreasing levels of quality are: level 1, level 2A and level 2B assets.
Under Basel III, level 1 assets are not discounted when calculating the LCR, while level 2A and level 2B assets have a 15% and 50% discount, respectively. Level 1 assets include Federal Reserve bank balances, foreign resources that can be withdrawn quickly, securities issued or guaranteed by specific sovereign entities, and U.S. government issued or guaranteed securities.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 by U.S. government-sponsored enterprises. Level 2B assets include publicly-traded common stock and investment-grade corporate debt securities issued by non-financial sector corporations.
Liquidity Coverage Ratio Calculation Example
The LCR is calculated by dividing a bank's high-quality liquid assets by its total net cash flows, over a 30-day stress period. For example, let’s assume bank ABC has high-quality liquid assets worth $55 million and $35 million in anticipated net 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.
For the all-important “HQLA” in the numerator = Level 1 liquid asset amount + Level 2A liquid asset amount + Level 2B liquid asset amount – max (Unadjusted excess HQLA amount; Adjusted excess HQLA amount), where Level 1 liquid asset amount = Level 1 liquid assets that are eligible HQLA – Reserve balance requirement.
The chief takeaway Basel III expects banks to glean from the formula, is the expectation to achieve a leverage ratio in excess of 3%. To conform to the requirement, the Federal Reserve Bank of the United States fixed the leverage ratio at 5% for insured bank holding companies, and 6% for the aforementioned SIFIs. However most banks will attempt to maintain a higher capital to cushion themselves from financial distress, even as they lower the number of loans issued to borrowers.