Liquidity Coverage Ratio (LCR)
What Is the Liquidity Coverage Ratio (LCR)?
The liquidity coverage ratio (LCR) alludes to the proportion of highly liquid assets held by financial institutions, to guarantee their ongoing ability to meet short-term obligations. This ratio is basically a generic stress test that means to expect expansive shocks and ensure that financial institutions have suitable capital preservation, to brave any short-term liquidity disruptions, that might torment the market.
Grasping the Liquidity Coverage Ratio (LCR)
The liquidity coverage ratio (LCR) is a chief focus point from the Basel Accord, which is a series of regulations developed by The Basel Committee on Banking Supervision (BCBS). The BCBS is a group of 45 delegates from major global financial centers. One of the objectives of the BCBS was to order banks to hold a specific level of highly liquid assets and keep up with certain levels of fiscal solvency to deter them from lending high levels of short-term debt.
Accordingly, banks are required to hold an amount of high-quality liquid assets that is sufficient to fund cash outflows for 30 days. High-quality liquid assets incorporate only those with a high potential to be converted effectively and quickly into cash. The three categories of liquid assets with decreasing levels of quality are level 1, level 2A, and level 2B.
Thirty days was picked in light of the fact that it was trusted that in a financial crisis, a response to protect the financial system from governments and central banks would commonly happen in 30 days or less. As such, the multi day period permits banks to have a cushion of cash in the event of a run on banks during a financial crisis. The 30-day requirement under the LCR additionally gives central banks, for example, the Federal Reserve Bank time to step in and carry out corrective measures to settle the financial system.
Under Basel III, level 1 assets are not discounted while working out the LCR, while level 2A and level 2B assets have a 15% and a 25-half discount, individually. Level 1 assets incorporate Federal Reserve bank balances, foreign assets that can be removed quickly, securities issued or guaranteed by specific sovereign elements, and U.S. government-issued or guaranteed securities.
Level 2A assets incorporate securities issued or guaranteed by specific multilateral development banks or sovereign substances, and securities issued by U.S. government-sponsored ventures. Level 2B assets incorporate publicly traded common stock and speculation grade corporate debt securities issued by non-financial sector corporations.
The chief focal point that Basel III anticipates that banks should gather from the formula is the expectation to accomplish a leverage ratio in excess of 3%. To conform to the requirement, the Federal Reserve Bank of the United States fixed the leverage ratio at 5% for insured bank holding companies, and 6% for systemically important financial institutions (SIFIs). Notwithstanding, most banks will endeavor to keep a higher capital to cushion themselves from financial distress, even on the off chance that it means giving less loans to borrowers.
The most effective method to Calculate the LCR
Working out LCR is as per the following:
- The LCR is calculated by separating a bank's high-quality liquid assets by its total net cash flows, north of a 30-day stress period.
- The high-quality liquid assets incorporate only those with a high potential to be converted effectively and quickly into cash.
- The three categories of liquid assets with decreasing levels of quality are level 1, level 2A, and level 2B.
For instance, we should expect bank ABC has high-quality liquid assets worth $55 million and $35 million in anticipated net cash flows, more than a 30-day stress period:
- The LCR is calculated by $55 million/$35 million.
- Bank ABC's LCR is 1.57, or 157%, which meets the requirement under Basel III.
Implementation of the LCR
The LCR was proposed in 2010 with revisions and last endorsement in 2014. The full 100% least was not required until 2019.
The liquidity coverage ratio applies to all banking institutions that have more than $250 billion altogether consolidated assets or more than $10 billion in on-balance sheet foreign exposure. Such banks — frequently alluded to as SIFI — are required to keep a 100% LCR, and that means holding an amount of highly liquid assets that are equivalent or greater than its net cash flow, north of a 30-day stress period. Highly liquid assets can incorporate cash, Treasury bonds, or corporate debt.
LCR versus Other Liquidity Ratios
Liquidity ratios are a class of financial metrics used to determine an organization's ability to pay off current debt obligations without raising outside capital. Liquidity ratios measure an organization's ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio. Current liabilities are broke down in relation to liquid assets to assess the coverage of short-term debts in an emergency.
The liquidity coverage ratio is the requirement by which banks must hold an amount of high-quality liquid assets that is sufficient to fund cash outflows for 30 days. Liquidity ratios are like the LCR in that they measure an organization's ability to meet its short-term financial obligations.
Limitations of the LCR
A limitation of the LCR is that it expects banks to hold more cash and could lead to less loans issued to consumers and organizations. One could contend that assuming that banks issue a less number of loans, it could lead to more slow economic growth since companies that need access to debt to fund their operations and expansion wouldn't approach capital.
On the other hand, another limitation is that we won't be aware until the next financial crisis on the off chance that the LCR gives a sufficient financial cushion for banks or on the other hand in the event that subsidizing cash outflows for 30 days is deficient. The LCR is a stress test that expects to ensure that financial institutions have adequate capital during short-term liquidity disruptions.
Highlights
- Of course, we won't be aware until the next financial crisis on the off chance that the LCR gives a sufficient financial cushion for banks or on the other hand assuming it's deficient.
- The LCR is a requirement under Basel III by which banks are required to hold an amount of high-quality liquid assets that is sufficient to fund cash outflows for 30 days.
- The LCR is a stress test that intends to expect all inclusive shocks and ensure that financial institutions have suitable capital preservation to brave any short-term liquidity disruptions.
FAQ
What Are the Basel Accords?
The Basel Accords are a series of three sequential banking regulation agreements (Basel I, II, and III) set by the Basel Committee on Bank Supervision (BCBS). The BCBS is a group of 45 delegates from major global financial centers. The Committee gives recommendations on banking and financial regulations, specifically, concerning capital risk, market risk, and operational risk. The accords guarantee that financial institutions have sufficient capital on account to assimilate startling losses. The liquidity coverage ratio (LCR) is a chief focal point from the Basel Accord.
What Are Some Limitations of the LCR?
A limitation of the LCR is that it expects banks to hold more cash and could lead to less loans issued to consumers and organizations which could bring about more slow economic growth. Another is that it won't be known until the next financial crisis assuming the LCR furnishes banks with a sufficient financial cushion to make due before governments and central banks could act the hero.
What Is the LCR for a SIFI?
A systemically important financial institution (SIFI) is a bank, insurance, or other financial institution that U.S. federal regulators determine would represent a serious risk to the economy if it somehow managed to collapse. Currently, these are defined as banking institutions that have more than $250 billion altogether consolidated assets or more than $10 billion in on-balance sheet foreign exposure. They are required to keep a 100% LCR, and that means holding an amount of highly liquid assets that are equivalent or greater than its net cash flow, north of a 30-day stress period.
