Liquidity Coverage Ratio (LCR): What Is It?

The percentage of highly liquid assets financial institutions hold to guarantee their continued capacity to fulfill short-term obligations is known as the liquidity coverage ratio, or LCR. This ratio is a general-purpose stress test designed to predict market-wide shocks and ensure that financial institutions have adequate capital preservation to withstand any potential short-term liquidity disruptions.

Knowledge of the LCR (Liquidity Coverage Ratio)

One of the most critical lessons from the Basel Accord, a set of rules created by the Basel Committee on Banking Supervision (BCBS), is the liquidity coverage ratio (LCR). Forty-five delegates representing important international financial hubs make up the BCBS. One of the objectives of the BCBS was to prevent banks from lending large amounts of short-term debt by requiring them to maintain certain levels of fiscal stability and keep a specified amount of highly liquid assets. Consequently, banks must maintain high-quality liquid assets to cover cash outflows for thirty days.

Only assets with solid potential to be swiftly and readily turned into cash are considered high-quality liquid assets. Level 1, Level 2A, and Level 2B are the three categories of liquid assets with descending quality levels.

Thirty days was chosen because it was thought that during a financial crisis, governments and central banks would respond to save the financial system within that time frame. Put differently, the 30-day window gives banks a cash buffer in case there is a bank run during a financial crisis. The LCR’s 30-day deadline gives central banks, like the Federal Reserve Bank, extra time to intervene and put remedial measures in place to stabilize the financial system.

Basel III does not discount level 1 assets when determining the LCR; however, level 2A and level 2B assets are discounted by 15% and 25–50%, respectively. Level 1 assets include bank balances held by the Federal Reserve, readily accessible foreign funds, securities guaranteed or issued by particular sovereign states, and securities guaranteed or issued by the United States government.

Level 2A assets include securities issued or guaranteed by certain multilateral development banks or sovereign organizations, including securities issued by U.S. government-sponsored businesses. Publicly traded common stock and investment-grade corporate debt securities issued by businesses outside the banking sector are examples of level 2B assets.

The main conclusion that banks should draw from the calculation according to Basel III is that they should aim for a leverage ratio higher than 3%. To conform to the rule, the Federal Reserve Bank of the United States fixed the leverage ratio at 5% for insured bank holding companies and 6% for systemically significant financial institutions (SIFIs). However, most banks will aim to retain more outstanding capital to buffer themselves against financial trouble, even if it means giving fewer loans to consumers.

Methods for Computing the LCR

To calculate LCR, use this formula:

LCR=High quality liquid asset amount (HQLA)/Total net cash flow amount​

• ‏The LCR is computed over a 30-day stress period by dividing the bank’s total net cash flows by the number of high-quality liquid assets.
• Only those assets with solid potential to be swiftly and readily turned into cash are considered high-quality liquid assets.
• Level 1, Level 2A, and Level 2B are the three categories of liquid assets with descending quality levels.

For illustration, suppose bank ABC has $55 million in high-quality liquid assets and $35 million in projected net cash flows during a 30-day stress period:

• $55 million divided by $35 million yields the LCR.
• Bank ABC satisfies Basel III requirements with an LCR of 1.57 or 157%.

Applicability of the LCR

The LCR was first suggested in 2010, revised, and approved in 2014. It wasn’t until 2019 that the whole 100% minimum was necessary.

Any financial institution with more than $250 billion in total consolidated assets or more than $10 billion in foreign exposure on the balance sheet is subject to the liquidity coverage ratio.

These banks—often called SIFI—must maintain a 100% LCR throughout a 30-day stress test, which entails retaining highly liquid assets equal to or greater than its net cash flow. Very liquid assets include cash, corporate debt, and Treasury bonds.

Differential Liquidity Ratios versus LCR

One type of financial indicator, liquidity ratios, assesses a company’s capacity to settle its outstanding debts without raising additional funds. By calculating measures like the current ratio, quick ratio, and operating cash flow ratio, liquidity ratios assess a company’s capacity to meet debt commitments as well as its margin of safety. The analysis of current liabilities is compared with liquid assets to see how well short-term debts are covered in an emergency.

The requirement that banks maintain a sufficient quantity of high-quality liquid assets to cover cash outflows for 30 days is known as the liquidity coverage ratio.

Liquidity ratios and the LCR are comparable in assessing a company’s capacity to pay short-term debt.

Constraints on the LCR

One drawback of the LCR is that it makes banks keep more capital, which could result in fewer loans being given to individuals and companies. If banks were to lend less money, the economy would grow more slowly because businesses that depend on debt to finance their operations and expansion could not obtain cash.

However, another drawback is that we won’t know if the LCR gives banks enough financial cushion or if it won’t cover cash withdrawals for 30 days until the next financial crisis. The purpose of the LCR stress test is to ensure that financial institutions have enough capital to withstand temporary disruptions in their supply of funds.

The Basel Accords: What Are They?

The Basel Committee on Bank Supervision (BCBS) established a set of three consecutive banking regulation accords known as the Basel Accords (Basel I, II, and III). Forty-five delegates representing important international financial hubs make up the BCBS. In particular, the Committee recommends capital, market, and operational risks in banking and financial laws. The agreements guarantee that financial institutions maintain sufficient reserves to cover unforeseen losses.

A critical lesson from the Basel Accord is the liquidity coverage ratio (LCR).

What Are The LCR’s Restrictions?

One drawback of the LCR is that it makes banks keep more cash, which may result in fewer loans being given to individuals and companies, which could slow down economic growth. Another is that if the LCR gives banks enough financial cushion to survive until governments and central banks step in to save them, it will be known in the next financial crisis.

What Does a SIFI’s LCR Mean?

A bank, insurance company, or other financial organization that U.S. federal authorities determine would present a significant risk to the economy in the event of its collapse is referred to as a systemically important financial institution (SIFI). These are now classified as banking institutions with international exposure on their balance sheet exceeding $10 billion or total consolidated assets exceeding $250 billion. Throughout a 30-day stress period, they must keep highly liquid assets equivalent to or higher than their net cash flow or maintain a 100% LCR.

Conclusion

• The LCR is a Basel III rule that requires banks to retain enough high-quality liquid assets to cover cash withdrawals for 30 days.
• The LCR is a stress test designed to predict market-wide shocks and ensure financial institutions have adequate capital reserves to weather any short-term liquidity shortages.
• We won’t know whether the LCR provides a sufficient financial buffer for banks until the next financial crisis.