Liquidity Coverage Ratio - Explained
What is a Liquidity Coverage Ratio?
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Table of ContentsWhat is a Liquidity Coverage Ratio?How Does the Liquidity Coverage Ratio Work?Estimating Total Cash OutflowsEstimating High-Quality Liquid Assets (HQLA)What Does the LCR Tell YouImplementation of the LCRHigh-Quality Liquid AssetsKEY TAKEAWAYSExample of the LCRThe Difference Between the LCR and Liquidity RatiosLimitations of Using the LCR
What is a Liquidity Coverage Ratio?
The Liquidity Coverage Ratio is a requirement under Basel III for a bank to hold high-quality liquid assets (HQLAs) sufficient to cover 100% of its stressed net cash requirements over 30 days.
How Does the Liquidity Coverage Ratio Work?
The supervisory model taking the stress period into details combines the constituents of bank-specific liquidity and market-wide stress, without excluding most of the shocks experienced between 2007 and 2012. The minimum period for a bank's management or supervisors as deemed fit to take necessary corrective actions is the 30 days stress period. The LCR is mainly used as a stress test, whose purpose is to expect market-wide shocks while making sure that appropriate capital reservation is held by financial institutions to over-ride any liquidity interruptions in the short-term. The Liquidity Coverage Ratio is designed to make sure banks hold a sufficient reserve of High-quality Liquid Assets (HQLA) to allow them to scale through a period of significant liquidity stress lasting 30 calendar days. Internationally active banks require the Liquidity Coverage Ratio to hold a stock of HQLA which is at least as large as its expected total net cash outflows over the stress period. Mathematically, LCR is expressed as: LCR = High-quality Liquid Assets (HQLA) / Total expected cash outflows. where: High-quality Liquid Assets (HQLA) = assets that can be easily converted to money, and Total expected cash outflows = total cash outflows in a stress scenario with a minimum value of 100%.
Estimating Total Cash Outflows
The total cash outflows are defined as the difference between the total expected cash outflows and the total expected cash inflows arising in the stress scenario. By multiplying the outstanding balances of different categories of liabilities and commitments made by the supervisory rates at which they are expected to be drawn down, which are off the balance sheet; we arrive at the Total expected outflows. The value of the total expected cash inflows is gotten by the application of inflow rates to the outstanding balances of various contractual receivables. The minimum size of the HQLA stock is estimated by subtracting the stressed inflows from the outflows.
Estimating High-Quality Liquid Assets (HQLA)
If a liquid asset is not burdened, meets the minimum liquidity standard and it has reflected that it can be disposed of to produce liquidity as when needed, it can be included in the stock of HQLA. HQLA include various levels which are:
- Level 1 assets: assets that can be included without limit.
- Level 2 assets: assets that cannot exceed 40% of the liquidity reserve. Level 2 assets are further subdivided into:
- Level 2A assets: assets whose value is subject to a 15% haircut.
- Level 2B assets: assets that are subject to higher haircuts but cannot exceed 15% of the stock of HQLA.
What Does the LCR Tell You
To improve the speed at which internationally active banks recover from short-term liquidity shocks, the Basel Committee on Banking Supervision (BCBS) - a group consisting of 27 representatives from key global financial centers whose goal includes but is not limited to enforcing banks to hold a required amount of highly liquid assets and maintain specified levels of fiscal solvency to prevent them from lending high levels of short-term debt, introduced the LCR as a constituent of the Basel III post-crisis reforms. The LCR ensures that banks hold a sufficient reserve of high-quality liquid assets (HQLA) to allow them to make it through a period of liquidity stress, which is usually 30 calendar days.
Implementation of the LCR
The LCR originally-proposed changes (2010) by the BCBS before implementing its final version on 15 April 2014 is summarized below:
- There will be a raise of quality, consistency, and transparency of the capital base.
- The risk coverage of the capital framework will be strengthened.
- There will be an introduction of a leverage ratio to act as a supplementary measure to the Basel II risk-based framework.
- Introduction of a series of measures to enhance the accumulation of capital buffers in good times that can be drawn upon in stress periods.
- For internally active banks, a global minimum liquidity standard is brought in place, including a 30-day liquidity coverage ratio requirement supported by a longer-term structural liquidity ratio called the "Net Stable Funding Ratio".
High-Quality Liquid Assets
The haircuts and caps for each asset eligible to be included as HQLA have been listed in great detail by the Bank for International Settlements (BIS). Taking a look at sovereign bonds such as US Treasury securities, they are regarded as Level 1 assets, without cap and a 0% haircut. A US corporate bond with an AA+ credit rating from S&P is placed under a 40% cap and 25% haircut. Common equity is subject to a 40% cap and 50% haircut. The list of asset classes eligible to be treated as HQLA is as follows:
- Coins and notes
- Central bank reserves
- Claims on sovereigns and central banks
- Public-sponsored entities
- Investment-grade corporate debt
- High-quality RMBS rated AA or higher.
- To improve the speed at which internationally active banks recover from short-term liquidity shocks, the Basel Committee on Banking Supervision (BCBS) introduced the Liquid Coverage Ratio (LCR) as a constituent of the Basel III post-crisis reforms.
- The Liquidity Coverage Ratio is a requirement under Basel III for a bank to hold high-quality liquid assets (HQLAs) sufficient to cover 100% of its stressed net cash requirements over 30 days
- Internationally active banks require the Liquidity Coverage Ratio to hold a stock of HQLA which is at least as large as its expected total net cash outflows over the stress period.
- The LCR was implemented and measured in 2011, but the full 100% minimum was not enforced until 2015.
Example of the LCR
Listed below are Bank X's data outlining it's liquid assets and expected cash flows over a 30 days stress period. In the year 2019, Bank X's:
- Highly Liquid Assets is $1150
- Average monthly withdrawals are $540, and
- The expected monthly withdrawals in a stress period are $1000.
In the year 2020, Bank X's:
- Highly Liquid Assets is $1300
- Average monthly withdrawals is $500, and
- The expected monthly withdrawals in a stress period is $1200.
Bank X's LCR as of 2019 is calculated as $1150 / $1000 which gives a value of 1.15 or 115%. Its LCR as of 2020 is calculated as $1300 / $1200 which gives a value of 1.08 or 108%. Bank X's LCR meets the requirement under Basel III in both years.
The Difference Between the LCR and Liquidity Ratios
The liquidity ratio is a type of computation that is used to measure the ability of a company to pay its short-term debts. There are three common categories of calculations that fall under liquidity ratios - the current ratio which is the least conservative of the three, followed by the acid ratio, and the cash ratio. Financial analysts often group these three ratios when trying to measure the liquidity of a company accurately. The Liquidity Coverage Ratio, on the other hand, is a requirement under Basel III for a bank to hold high-quality liquid assets (HQLAs) sufficient to cover 100% of its stressed net cash requirements over 30 days.
Limitations of Using the LCR
There are three major sets of issues encountered with the LCR:
- One relates to the LCR's scope of application. National supervisors may extend this scope to all banks in their jurisdictions. They may also enforce stricter liquidity requirements because the LCR is a minimum requirement like all BCBS standards.
- The second issue relates to the compulsory usage of monitoring tools developed by the BCBS to supplement the LCR.
- The last issue is related to practical implementation considerations. These create a need for supervisors to subsequently evaluate the characteristics of banks' assets used as HQLA, and their cash flow assumptions as part of their Pillar 2 Supervisory Reviews.