Liquidity Coverage Ratio

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What is the Liquidity Coverage Ratio (LCR)?

The ability of a bank to meet its short-term liquidity demands in a stress scenario is gauged by its liquidity coverage ratio or LCR. It contrasts the estimated net cash outflows for a bank over a 30-day period with the value of the bank's high-quality liquid assets (HQLA). The Basel III regulatory framework includes the LCR in an effort to strengthen banks' ability to withstand financial crises.

Why is Liquidity Coverage Ratio (LCR) important?

Because it guarantees that banks have adequate liquid assets to withstand a significant liquidity shock, such as a bank run, a disruption in the market, or a fall in credit rating, liquidity coverage ratios, or LCRs, are crucial.

Banks can prevent forced asset sales, fire sales, and expensive borrowing—all of which could exacerbate their financial position and raise systemic risk—by maintaining an adequate level of HQLA. Additionally, banks are encouraged under the LCR to lessen their reliance on short-term wholesale funding, which can be expensive and unstable, and to diversify their sources of funding.

What is the formula for Liquidity Coverage Ratio (LCR)?

The formula for Liquidity Coverage Ratio (LCR) is:

LCR = High-Quality Liquid Assets (HQLA) / Total Net Cash Outflows over 30 days

HQLA are assets that can be easily and quickly converted into cash at little or no loss of value. They are classified into three levels, depending on their liquidity and credit quality:

• Level 1 assets include cash, central bank reserves, and marketable securities backed by sovereigns or central banks. They are not subject to any haircut or discount in the LCR calculation.
• Level 2A assets include securities issued by government-sponsored enterprises, multilateral development banks, or sovereign entities with a credit rating of at least AA-. They are subject to a 15% haircut in the LCR calculation.
• Level 2B assets include corporate debt securities, covered bonds, residential mortgage-backed securities, and common equity shares with a credit rating of at least BBB-. They are subject to a 50% haircut in the LCR calculation.

The predicted cash outflows less the expected cash inflows under a stress scenario over a 30-day horizon equals the total net cash outflows over 30 days. Depending on the stability and contractual maturity of the various liability categories and off-balance sheet exposures, different run-off rates are applied to determine the cash outflows.

Depending on the marketability and liquidity of each asset class, different inflow rates are applied to determine the cash inflows. In order to prevent banks from too depending on anticipated inflows to meet their liquidity needs, the overall amount of cash inflows is regulated at 75% of the entire amount of cash outflows.

The minimum LCR requirement is 100%, meaning that banks must hold enough HQLA to cover their total net cash outflows over 30 days.

How to calculate the Liquidity Coverage Ratio (LCR)?

To calculate the LCR, banks must first know the value of their HQLA and their projected net cash outflows for the next 30 days.

HQLA assets are those that can be swiftly and simply turned into cash with little to no value loss. With progressively lower levels of quality and liquidity, they are separated into three categories: Level 1, Level 2A, and Level 2B. When figuring out the LCR, Level 2A and Level 2B assets receive a 15% and a 25–50% discount, respectively, while Level 1 assets are not reduced.

Total net cash outflows are the difference between the expected cash outflows and the expected cash inflows in the next 30 days. Cash outflows are mainly driven by the bank's liabilities, such as deposits, debt securities, and off-balance sheet commitments.

Cash inflows are mainly driven by the bank's assets, such as loans, securities, and derivatives. However, cash inflows are capped at 75% of cash outflows to ensure that banks maintain a minimum level of HQLA.

Examples of the LCR

Let's assume that Bank A has the following balance sheet items:

• Cash: $100 million
• Central bank reserves: $50 million
• Treasury bills: $200 million
• Corporate bonds (rated AA): $150 million
• Residential mortgage-backed securities (rated AAA): $100 million
• Loans to customers: $500 million
• Deposits from customers: $700 million
• Wholesale funding: $300 million
• Contingent liabilities: $50 million

We can calculate the HQLA and the total net cash outflows as follows:

HQLA = Cash + Central bank reserves + (Treasury bills * 100%) + (Corporate bonds * 85%) + (Residential mortgage-backed securities * 85%)

HQLA = $100 million + $50 million + ($200 million * 100%) + ($150 million * 85%) + ($100 million * 85%)

HQLA = $537.5 million

Total net cash outflows = Cash outflows - Min (Cash inflows, 75% of cash outflows)

Cash outflows = (Deposits from customers * Run-off rate) + (Wholesale funding * Run-off rate) + (Contingent liabilities * Draw-down rate)

Cash inflows = (Loans to customers * Expected repayment rate)


Assuming that the run-off rates for deposits and wholesale funding are 10% and 20%, respectively, and the draw-down rate for contingent liabilities is 5%, we get:

Cash outflows = ($700 million * 10%) + ($300 million * 20%) + ($50 million * 5%)
Cash outflows = $70 million + $60 million + $2.5 million
Cash outflows = $132.5 million


Assuming that the expected repayment rate for loans is 50%, we get:

Cash inflows = ($500 million * 50%)
Cash inflows = $250 million


Since cash inflows are capped at 75% of cash outflows, we get:

Total net cash outflows = Cash outflows - Min (Cash inflows, 75% of cash outflows)
Total net cash outflows = $132.5 million - Min ($250 million, $99.375 million)
Total net cash outflows = $132.5 million - $99.375 million
Total net cash outflows = $33.125 million


Finally, we can calculate the LCR as:

LCR = HQLA / Total net cash outflows over 30 days
LCR = $537.5 million / $33.125 million
LCR = 16.23

This means that Bank A has more than enough HQLA to cover its potential net cash outflows over the next 30 days.

Limitations of the LCR

The LCR is a useful metric to measure the short-term liquidity risk of banks, but it also has some limitations, such as:

• Because it is based on a standardized scenario, it might not accurately reflect the unique risks and features of any given bank or market.
• It doesn't take into consideration the risk associated with market liquidity or the effect selling big quantities of assets in a stressful scenario has on prices.
• In a systemic crisis, it ignores the linkages and feedback loops between banks and other financial institutions.
• It might encourage banks to hoard liquid assets or cut back on lending, which would be bad for the actual economy.
• It may not be enough to stop bank runs or liquidity crises because it depends on depositors, creditors, and regulators' faith and expectations.

FAQ

The three categories of High-Quality Liquid Assets (HQLA) are Level 1, Level 2A, and Level 2B.

The LCR is important for banks as it ensures that they have an adequate proportion of high-quality liquid assets to fulfill total net cash outflows over the next 30 calendar days². This provides a short-term solution to possible liquidity problems.

In the LCR calculation, Level 1 assets are not discounted, while Level 2A and Level 2B assets have a 15% and a 25-50% discount, respectively.

The current minimum required by regulators for the Liquidity Coverage Ratio is 100%, meaning institutions must have enough unencumbered assets to cover any potential net cash outflows over the next 30 days.

The 30-day requirement under the LCR allows banks to have a cushion of cash in the event of a run on banks during a financial crisis. It also provides central banks such as the Federal Reserve Bank time to step in and implement corrective measures to stabilize the financial system.