What is the Liquidity Coverage Ratio (LCR)?

Liquidity Coverage Ratio was invented due to the events of the financial crisis that may be disastrous for the global economy.

The liquidity coverage ratio (LCR) is a ratio of highly liquid assets held by financial institution to its expected cash outflows, to meet its short-term obligation. This ratio is essentially a generic stress test that tells how likely a financial institute can withstand a market recession and make sure that they have suitable capital preservation, to meet any short-term obligations that may plague the market.

The Liquidity coverage ratio (LCR) is one of the ratios required under Basel III whereby financial institutions need to hold an amount of high-quality liquidity assets (HQLA) that they need to withstand a 30-days cash outflow under difficult situation. It is used to compute and mitigate the systematic risks that exist within the banking sector. The Basel Committee forces the financial institute to avoid excess lending with aim of getting risky returns or profits.

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Understanding the Liquidity Coverage Ratio (LCR)

The LCR falls under the Basel Accord, which is a series of regulations developed by the Basel committee on Banking Supervision (BCBS).  The committee offers recommendations on banking and financial regulations, operational risk, concerning capital risk, specifically and market risk.

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Image description: LCR is essentially a generic stress test that tells how a financial institute can withstand a market recession.

The Basel committee on Banking Supervision (BCBS) is the group of 45 representatives from the leading global financial centers with an objective to mandate financial institutions to hold a special level of highly liquid assets and maintain certain level of fiscal solvency to prevent them from advancing high levels of short-term debts.

Financial institutions need to hold an amount of high-quality liquid assets (HQLA) that include assets with high liquidity and are converted into cash easily that is adequate to fund cash outflows from 30 days.   The three categories of these assets with decreasing levels of quality are level 1, level 2A and level 2B.

Thirty days are chosen as it is believed that governments and central banks address the financial crisis situation usually within 30 days. The 30-days period enables financial institutions to have a cushion of cash in the event of a run on financial institution during a financial crisis and offers central banks such as the Federal Reserve Bank time to step in and execute corrective measures to stabilize to stabilize the financial system.

Under Basel III, while computing LCR for level 1 assets are not discounted, whereas level 2A and 2B assets have a 15% and a 25-50% discount, respectively. The Level 1 assets include securities issued or guaranteed y special sovereign entities, Federal Reserve Bank balance, US government-issued or guaranteed securities and foreign resources that can be withdrawn quickly.  

The Level 2A assets include securities issued by US government-sponsored enterprises and securities issued or guaranteed by sovereign entities or special multilateral development banks. The level 2B assets include investment-grade corporate debt securities and listed common stocks issued by non-financial sector corporations. 

The Basel III expects financial institutions to achieve a leverage ratio of more than 3% and the Federal Reserve Bank has fixed the leverage ratio at 5% for systemically important financial institutions (SIFIs). 

How to Calculate the LCR

Liquidity Coverage Ratio (LCR) = High quality assets amount (HQLA)/ Total net cash flow amount

• LCR is computed by dividing a financial institute’s high quality liquid assets by its total net cash flows, over a 30-day stress period.
• The high quality liquid assets (HQLA) consist of the assets that are highly liquid. Usually, it consists of marketable securities and cash and cash equivalents.
• The 30-days cash outflow is the cash flowing out the financial institute given a stress situation.
• The three categories of liquid assets with decreasing levels of quality include Level 1, Level 2A and Level 2B.

Implementation of Liquidity Coverage Ratio

The Liquidity Coverage Ratio was put forward in 2010 and was approved in 2014. Until 2019, the 100% minimum was not needed.

The ratio is applied to all financial institutions that have total consolidated assets of over $250 billion or on-balance sheet foreign exposure of over $10 billion. Such banks are known as systemically important financial institutions (SIFIs) and they need to maintain 100% of liquidity coverage ratio, which means maintaining highly liquid assets equal or greater than its net cash flow over a 30-daysress period. 

Limitation of the Liquidity Coverage Ratio

Liquidity Coverage Ratio is the necessary requirement that financial institute to hold more cash that may lead to less lending to consumers and businesses. Less lending’s may lead to economic slowdown as the business that needs money to finance their operations and expansion would not have access to capital.

It is difficult to determine if the Liquidity Coverage Ratio is enough for overcoming the financial crisis or it’s sufficient to fund cash outflows for 30 days.