In the event of a financial crisis, a run on the banks could prove disastrous for the global economy. That hasn’t gone unnoticed by the global financial industry, and it’s the reason why the LCR (liquidity coverage ratio) was invented. But what is the liquidity coverage ratio, and how could it help protect banks and financial institutions from financial collapse? Get the inside track on the LCR ratio with our liquidity coverage ratio summary.
Liquidity coverage ratio summary
Developed by the Basel Committee on Banking Supervision (BCBS) – a group of representatives from global financial centres – the LCR ratio is the main takeaway from the Basel Accord. It was first proposed in 2010 before it was given final approval in 2014, although the 100% minimum wasn’t required until 2019. But what does the LCR (liquidity coverage ratio) mean?
Put simply, the liquidity coverage ratio is a term that refers to the proportion of highly liquid assets held by financial institutions to ensure that they maintain an ongoing ability to meet their short-term obligations (i.e., cash outflows for 30 days). 30 days was selected because, in a financial crisis, a response from governments and central banks would typically take around 30 days.
In other words, the liquidity coverage ratio is a stress test that is intended to make sure that banks and financial institutions have a sufficient level of capital to ride out any short-term disruptions to liquidity. It applies to banks with over $250 billion in total consolidated assets or banks with over $10 billion in on-balance sheet foreign exposure.
Understanding the LCR ratio formula
There is a simple LCR ratio formula that you can use to calculate LCR:
LCR = High-Quality Liquid Asset Amount (HQLA) / Total Net Cash Flow Amount
So, to calculate the LCR (liquidity coverage ratio), you’ll need to divide the bank’s high-quality liquid assets by their total net cash flows over the course of a specific, 30-day stress period.
What is a HQLA?
HQLAs are assets with the potential to be converted into cash quickly and easily. Under the Basel Accord, there are three categories of liquid assets – level 1, level 2A, and level 2B:
Level 1 – These assets include coins and banknotes, central bank reserves, and marketable securities. Level 1 assets aren’t discounted when you calculate the LCR ratio.
Level 2A – These assets include securities issued/guaranteed by specific sovereign entities or multilateral development banks, as well as securities issued by US government-sponsored enterprises. Level 2A assets have a 15% discount.
Level 2B – These assets include investment-grade corporate debt and publicly-traded common stock. Level 2B assets have a 25-50% discount.
Banks and financial institutions should attempt to achieve a liquidity coverage ratio of 3% or more. In most cases, banks will maintain a higher level of capital to give themselves more of a financial cushion.
Limitations of the liquidity coverage ratio
The LCR ratio formula is immensely important because it ensures that banks and financial institutions have a substantial financial cushion in a crisis. However, there are a couple of significant limitations associated with LCR (liquidity coverage ratio). Firstly, it requires banks to hold onto more cash. Consequently, fewer loans could be issued to businesses or consumers. It’s also crucial to remember that it’s impossible to know whether the LCR ratio provides a strong enough financial cushion for banks until the next financial crisis happens, at which point, the damage will already be done.
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