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
LCR Formula and Calculation
LCR=Total net cash flow amountHigh quality liquid asset amount (HQLA)
- 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.
- The high-quality liquid assets include only those with a high potential to be converted easily and quickly into cash.
- The three categories of liquid assets with decreasing levels of quality are level 1, level 2A, and level 2B.
- LCR is a requirement under Basel III whereby banks are required to hold an amount of high-quality liquid assets that's enough to fund cash outflows for 30 days.
- The LCR is a 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.
- Of course, we won't know until the next financial crisis if the LCR provides enough of a financial cushion for banks or if it's insufficient.
What the LCR Tells You?
The LCR is a chief takeaway from the Basel Accord, which is a series of regulations developed by The Basel Committee on Banking Supervision (BCBS). The BCBS is a group of 45 representatives from major global financial centers. One of the goals of the BCBS was to mandate banks to hold a specific level of highly liquid assets and maintain certain levels of fiscal solvency to discourage them from lending high levels of short-term debt.
As a result, banks are required to hold an amount of high-quality liquid assets that's enough to fund cash outflows for 30 days. Thirty days was chosen because it was believed that in a financial crisis, a response to rescue the financial system from governments and central banks would typically occur within 30 days.
In other words, the 30 day period allows banks to have a cushion of cash in the event of a run on banks during a financial crisis. The 30-day requirement under the LCR also provides central banks such as the Federal Reserve Bank time to step in and implement corrective measures to stabilize the financial system.
Implementation of the LCR
The LCR was proposed in 2010 with revisions and final approval in 2014. The full 100% minimum was not required until 2019. 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.
High-Quality Liquid Assets
The high-quality liquid assets include only those with a high potential to be converted easily and quickly into cash. As stated earlier, the three categories of liquid assets with decreasing levels of quality are level 1, level 2A, and level 2B.
Under Basel III, level 1 assets are not discounted when calculating the LCR, while level 2A and level 2B assets have a 15% and a 25-50% 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.
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 if it means issuing fewer loans to borrowers.
The LCR vs. Other Liquidity Ratios
Liquidity ratios are a class of financial metrics used to determine a company's ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio. Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency.
The liquidity coverage ratio is the requirement whereby banks must hold an amount of high-quality liquid assets that's enough to fund cash outflows for 30 days. Liquidity ratios are similar to the LCR in that they measure a company's ability to meet its short-term financial obligations.
Limitations of the LCR
A limitation of the LCR is that it requires banks to hold more cash and might lead to fewer loans issued to consumers and businesses.
One could argue that if banks issue a fewer number of loans, it could lead to slower economic growth since companies that need access to debt to fund their operations and expansion would not have access to capital.
On the other hand, another limitation is that we won't know until the next financial crisis if the LCR provides enough of a financial cushion for banks or if it's insufficient to fund cash outflows for 30 days. The LCR is a stress test that aims to make sure that financial institutions have sufficient capital during short-term liquidity disruptions.
Example of the LCR
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:
- The LCR is calculated by $55 million / $35 million.
- Bank ABC's LCR is 1.57, or 157%, which meets the requirement under Basel III.