The liquidity coverage ratio (LCR) is a measure to analyze the liquidity risk of an entity. The Basel III accord recommends an LCR of 100% for better liquidity risk management.
Let’s discuss what is the liquidity coverage ratio and how it is important for banks.
What is Liquidity Coverage Ratio (LCR)?
The liquidity coverage ratio refers to the ratio of a financial institution’s highly liquid assets to its total net cash outflows.
It is the capability of a financial institution to meet short-term liquidity needs. Usually, it is the ability to fulfill cash and liquidity requirements for 30 days.
This ratio provides a quick overview of an entity’s current liquidity position. In other words, it gives you an idea of cash and highly liquid assets held by an entity.
Highly liquid assets refer to current assets that can be converted to cash quickly.
The LCR came into effect after the Basel Accord. This accord provides a series of regulations to protect banks and other financial institutions from liquidity shocks and severe market downturns.
Federal governments and central banks around the world are now implementing the Basel III recommendations for liquidity and risk management of all banking and non-banking institutions.
How to Calculate Liquidity Coverage Ratio (LCR)?
LCR is the ratio of liquid assets to the total assets of an entity. It can be calculated by the formula given below.
Liquidity Coverage Ratio = ( Highly Liquid Assets/Total Net Cash Outflows ) ✖ 100
Highly liquid assets are those convertible to cash quickly. Net cash outflows of an entity are calculated by determining its inflows and outflows first.
Some entities will adjust net cash outflows for mismatches, currency conversion effects, short-term collateral calls, and other factors as well.
Both metrics in the formula are considered for a 30-day period. An entity should objectively calculate the value of its highly liquid assets based on their market values.
Basel Accord and the Implementation of LCR
The Basel Committee on Banking Supervision (BCBS) was formed in 2009-10. It proposed a series of regulations and voluntary reforms periodically.
The Basel III accord is a continuation of its earlier two versions. The proposal requires banks and financial institutions to maintain adequate capital requirements and address liquidity risks.
The Basel III accord particularly proposes a new set of regulations to manage short-term liquidity risks of financial and banking entities.
The US Federal Reserves has planned to implement the following points as suggested by the Basel III accord:
- Liquidity and risk-based capital assessment for banks and other entities with $50 billion in total assets or above.
- Gradual conversion of the current liquidity stress tests to a full Basel III model.
- Early financial remediation plans to address the short-term liquidity problems proactively.
- At least three-point testing on financing stability and liquidity tests for all institutions as proposed by the Federal Reserve.
The EU central banks have also proposed similar capital and liquidity risk management proposal in accordance with the Basel III accord.
Understanding Liquidity Coverage Ratio (LCR)
The BCBS represents 45 financial centers from across the world. It proposed a series of regulations and voluntary compliance requirements to address the financial risks of banking and non-banking entities in the aftermath of the global financial crisis of 2008-09.
One of the key aspects of these suggestions is to maintain adequate cash reserves to meet the liquidity requirements for 30 days.
Quantitative and Qualitative Reporting
The Basel III accord requires all financial entities to produce qualitative and quantitative reports on their liquidity risk management measures.
Quantitative reporting is a daily weighted or non-weighted average of an entity’s HQLAs to the ratio of its net cash outflows.
The weighted average contains metrics from industry-specific or adjusted factors. The daily reports are then converted to monthly and annual reports.
The qualitative reporting then includes a few other points.
The concentration of Funding Sources
It means diversifying the funding sources and managing concentration limits for each funding source.
An adequate arrangement will include a mix of funding sources like borrowings, customer deposits, secure funding, and shareholders’ equity funds.
This point addresses the fluctuating currency conversion rates. Financial entities are required to manage these currency mismatches and provide qualitative reporting on corrective measures undertaken.
Derivative Exposure and Collateral Calls
Financial entities require risk-mitigating plans to manage the derivative exposure arising from investments in local and international derivatives.
Similarly, risk management for inherent collateral calls from clients affects short-term liquidity and requires adequate measures.
The Composition of HQLAs
An entity may hold a different composition of its highly liquid assets as classified by rating agencies.
The entity should report and manage the composition risk as well.
What are High-Quality Liquid Assets (HQLA)?
Generally, liquid assets are current assets that can be converted into cash quickly. The Basel Accord classifies these highly liquid assets into three categories.
Level 1 Assets
Level 1 assets are the highest-quality liquid assets. These assets do not require a discount factor for calculating the HQLA concentration mix.
Common examples of level 1 assets include bank currency notes, coins, federal reserve balance, and marketable securities.
Level 2A Assets
Level 2A assets use a 15% discount factor in the HQLA formula. These assets are also convertible into cash quickly and easily.
These assets include securities issued by sovereign entities, central banks/governments, securities backed by the US government, and related entities.
Level 2B Assets
The level 2B assets are also considered liquid assets of high quality. However, these assets include a 20-25% discount factor in the HQLA formula.
Common examples of level 2B assets include investments held in public stocks, investment-grade debt securities, and other forms of corporate debt.
How is LCR Important for Banks?
One of the major causes of the global financial crisis of 2008 was the liquidity risk of banks. Many large banks couldn’t manage the short-term liquidity risk which led to a market crisis soon.
The Basel III accord guides the liquidity management measures banks should undertake. It provides a liquidity test tool for banks and non-banking entities.
The LCR rule helps banks to manage their short-term liquidity risks arising from bank-specific and market-specific shocks.
The LCR proposes adequate measures for banks to keep highly-quality liquid assets to manage net cash outflows for at least 30 days.
Managing short-term liquidity enables banks to bear market liquidity shocks until they devise a rescue plan. In other scenarios, adequate LCR measures help banks to manage liquidity crises without relying on external funding.
Example – LCR of Morgan Stanley Firm
Morgan Stanley’s held a composition of HQLAs of $ 239,316 million as of December 31, 2022. Its total cash outflows (unadjusted) were $ 178,413 million.
The total amount of adjustments for securities and mismatches is $3,120 million. Therefore, the net adjusted cash outflows are $ 181,533.
Using the LCR formula, we can now calculate its LCR.
Liquidity Coverage Ratio = (High-Quality Liquid Assets/Net Adjusted Cash Outflows) ✖ 100
LCR = ($239,316/181,533) ✖ 100
LCR = 181.32 0r 132%.
Alternative Liquidity Ratios
Banks and non-banking financial entities can use several other types of liquidity management tools as well.
For example, the Net Stable Funding Ratio (NSFR) is a useful alternative ratio for banks. It stresses the need for maintaining short-term liquidity through an adequate level of HQLAs.
The second point for the NSFR is to separate the liquid assets and long-term fixed assets from an entity’s short-term as well as long-term liabilities.
Similarly, banks can use other metrics like the quick ratio, current ratio, and operating cash flow ratios to measure and report liquidity risks.
What are the Limitations of LCR?
Maintaining an adequate level of HQLAs over a period of 30 days is a hypothetical recommendation only. It does not ensure that a financial entity can survive a market liquidity crisis with such reserves.
Then, it forces banks to hold more cash and liquid assets than investments. It can affect the profitability and risk management objectives of banks.
Fewer cash reserves also mean fewer resources for bank customers and may affect its investors as well. Then, the LCR proposals do not differentiate the level of entities based on their liquid assets. These rules require all banks and entities to maintain 100% LCR ratios.