Liquidity coverage ratio

Liquidity coverage ratio

Banks must keep a specific ratio of assets to liabilities. In the event of an economic catastrophe, this helps them maintain that they can meet their short-term obligations. It would help if you first understand how LCR functions to comprehend what it signifies in banking.  

Financial authorities worldwide have coined the phrase “liquidity coverage ratio,” or LCR, to refer to the highly liquid assets that must be kept in reserve by a bank or other lenders to pay short-term obligations and ensure capital preservation. Banks must adhere to the LCR to maintain a sound financial position and to protect the banking system’s stability as a whole. 

What is the liquidity coverage ratio? 

The percentage of highly liquid assets held by financial institutions as a security to ensure their ongoing ability to meet short-term obligations is known as the liquidity coverage ratio (LCR). 

To improve the banking sector’s resilience to financial shocks, the Basel Committee on Banking Supervision introduced the Liquidity Coverage Ratio (LCR) in 2010. The LCR is a supervisory measure that requires banks to hold high-quality liquid assets to cover their net cash outflows over 30 days.  

The liquidity coverage ratio aims to mitigate market-wide shocks and guarantee that lenders have adequate capital preservation to withstand potential short-term liquidity shortages. Banks use the LCR tool to ensure there is a sufficient amount of high-quality liquid assets on hand to cover overall net cash withdrawals over the upcoming 30 calendar days. 

Understanding LCR 

LCR lets a bank survive in times of crisis when its survival might otherwise be in jeopardy. Those who utilise banking services benefit since they don’t have to worry about losing their assets if the bank goes through a financial crisis.  

The LCR is a crucial part of the Basel III reforms, which were implemented following the global financial crisis of 2008. Implementing the LCR is a key step in ensuring that banks can weather  future financial shocks. Banks can better withstand any unforeseen events that may lead to a sudden cash outflow by having a sound liquidity position. 

By comparing the number of specific assets and liabilities a bank has in place to the number of bond issuances, this ratio assesses how much liquidity a bank should have. The LCR was initially suggested in 2010, revised, and approved in 2014. The absolute 100% requirement wasn’t necessary until 2019. 

Any financial institutions with more than US$250 billion in total consolidated assets or more than US$10 billion in on-balance sheet overseas exposure are subject to the liquidity coverage ratio. For a 30-day stress period, such banks, often called SIFI, must maintain a 100% LCR, which entails retaining a quantity of highly liquid assets equal to or higher than their net cash flow. 

Banks must adhere to the LCR as it is a key prudential measure to maintain a sound financial footing. As of 2023, all banks will be required to implement the LCR. 

How to calculate LCR 

Banks must first determine the value of their high-quality liquid assets (HQLA) and their anticipated net cash outflows for the following 30 days to compute the LCR. 

 

The formula for calculating LCR is the following: 

 

                           High-quality liquid assets or HQLA    

LCR = ————————————————————————— 

              Total net cash outflows over the next 30 calendar days 

Implementation of LCR 

There are a few key points to understand regarding the implementation of LCR. One is the LCR’s reach of application, which national supervisors may broaden to include all banks under their control. The fact that the LCR, like all Basel Committee on Banking Supervision (BCBS) criteria, is a minimum requirement means they might also apply more restrictive liquidity requirements.  

 The second concern relates to the requirement for using monitoring instruments created by the BCBS to enhance the LCR. Practical implementation considerations are the subject of the last issue. As part of their Pillar 2 supervisory reviews, supervisors must assess the characteristics of the assets that banks utilise as HQL and as their cash flow assumptions.  

 To prevent disruptions to the orderly strengthening of banking systems or ongoing financing of economic activity, the LCR became a minimum requirement for BCBS member countries on 1 January 2015, with the requirement set at 60% and rising by 10 percentage points annually to reach 100% on 1 January 2019. 

Examples of LCR 

The LCR of a bank can be understood and interpreted using the following example. The following formula would be used to determine Bank XYZ’s LCR if it had US$100 million in HQLA and anticipated US$150 million in net cash outflows over the following 30 days: 

LCR for Bank XYZ = US$100 million/ US$150 million = 66.7% 

With a 66.7% LCR, bank A falls short of the required 100% or above standard. To meet the criteria, it must either raise the value of its entire HQLA or lower its cash outflows. 

Frequently Asked Questions

With LCR, there are a few key limitations. Banks must keep more money on hand as a result. As a result, fewer loans may be given to consumers or enterprises. It’s also critical to remember that until the next financial crisis occurs, the harm will already have been done. Determining whether the LCR ratio offers banks a strong enough financial buffer will be impossible. 

A ratio of 1:1 is a good liquidity coverage ratio but is difficult to achieve.  

A high liquidity coverage ratio shows the bank has solid enough liquid assets to cover its anticipated cash withdrawals over 30 calendar days. 

With the new Basel III regulations, banks must have a minimum liquidity coverage ratio that gradually increases from 70% in 2016 to 100% by 2019. 

The liquidity coverage ratio aims to enhance a bank’s short-term resilience of its liquidity risk profile by guaranteeing it has enough high-quality liquid resources to withstand an acute stress scenario lasting one month. 

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