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.
Key Takeaways
- The 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.
Understanding the Liquidity Coverage Ratio (LCR)
The liquidity coverage ratio (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 ofshort-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. 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.
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.
Under Basel III, level 1 assets are notdiscounted 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, foreignresources 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 issuedby 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 that 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 systemically important financial institutions (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.
How to Calculate the LCR
Calculating LCR is as follows:
LCR=TotalnetcashflowamountHighqualityliquidassetamount(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.
For example, let’s assume bank ABC hashigh-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.
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 thathave more than $250 billion in total consolidatedassets ormore than $10 billion in on-balance sheet foreign exposure. Such banks—often referred to as 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.
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 thecurrent ratio, quick ratio, andoperating cash flow ratio. Current liabilitiesare analyzed in relation toliquid assetsto 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.
What Are the Basel Accords?
The Basel Accords are a series of three sequential banking regulation agreements (Basel I, II, and III) set by the Basel Committee on Bank Supervision (BCBS). The BCBS is a group of 45 representatives from major global financial centers. The Committee provides recommendations on banking and financial regulations, specifically, concerning capital risk, market risk, and operational risk. The accords ensure that financial institutions have enough capital on account to absorb unexpected losses. The liquidity coverage ratio (LCR) is a chief takeaway from the Basel Accord.
What Are Some 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 which could result in slower economic growth.Another one is that it won't be known until the next financial crisis if the LCR provides banks with enough of a financial cushion to survive before governments and central banks could come to their rescue.
What Is the LCR for a SIFI?
A systemically important financial institution (SIFI) is a bank, insurance, or other financial institution that U.S. federal regulators determine would pose a serious risk to the economy if it were to collapse. Currently, these are defined as banking institutions that have more than $250 billion in total consolidated assets or more than $10 billion in on-balance sheet foreign exposure. They 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.
