INTRODUCTION TO LIQUIDITY COVERAGE RATIO (LCR)
Liquidity Coverage Ratio (LCR) According to Basel III Accord for Liquidity Reporting, LCR is an essential measure defined to make certain that global financial institutions hold sufficient high quality liquid asset (HQLA).
These assets are expected to cover short-term liabilities especially during period of financial stress within the next 30 day.
The LCR, by way of aspiration, is aimed at enhancing security in the banking industry by lowering the probability of emergence of positions containing insufficient liquidity to meet its holdings.
The LCR requires banks to maintain enough cash and other assets that can be easily converted to cash to meet for their net cash outflow during stress period thereby creating confidence on the ability of the bank to deal with the short-term liquidity risk.
It is especially useful in managing the spillover effects of financial crises, especially as captured during the full-blown meltdown in late 2008.
WHO REQUIRES TO USE LIQUIDITY COVERAGE RATIO (LCR)?
The LCR is primarily used by:
Banks and Financial Institutions:
- It is a regulatory compliance necessary for G-SIBs and other large banks as per the Basel III norms.
- LCR measures may also be used by some small banks as standards within their internal practices of liquidity risk management.
Regulators and Central Banks:
- Supervisory agencies pay particular attention to LCR standards for maintaining stability of the financial sector.
- Systemic liquidity risk, for instance, accumulated by the Reserve Bank of India (RBI) or the Federal Reserve, is measured by LCR.
Investors and Analysts:
- The better the LCR, the higher the possibilities that the bank is in a good shape, and this makes the ratio to a very important tool of investment evaluation.
Internal Risk Management Teams:
- The internal teams of banks use LCR calculations to enhance approaches to liquidity management and minimize operational risks.
TYPES OF LIQUIDITY COVERAGE RATIO
The LCR can be classified into the following categories based on the components of liquidity measurement:
HQLA Classification:
- Level 1 Assets: Free of risk and easily sellable assets like cash, reserves at the central bank and government bonds.
- Level 2A Assets: Investment securities of good quality such as bonds of corporate issues with rating of AA and above.
- Level 2B Assets: Some equities and sub investment grade bonds.
Stress Scenarios:
- Regulatory Stress Scenarios: Explanations of defined stress conditions provided by regulators used in LCR compliance testing.
- Internal Stress Scenarios: Special tests solely for determining the liquidity problems particular to each bank.
Adjusted Ratios:
- Static LCR: Imagines that there is no variation in the cash generation and the make-up of the balance sheet over the period of 30 days of stress.
- Dynamic LCR: Factors in the deterioration in the behavior of cash flows and asset liquidity over the stress period.
HOW TO CALCULATE LIQUIDITY COVERAAGE RATIO
The measure of Liquidity coverage ratio can be obtained by dividing the stock of high-quality liquid assets by the value of the linguistic variable which represents the net cash outflows over the next 30 days.
The LCR formula is straightforward:
LCR (%) = (High Quality Liquid Assets/NCO) x 100
Steps for Calculation:
Determine High-Quality Liquid Assets (HQLA):
- First of all, to determine the general strategy of buying Level 1, Level 2A and Level 2B assets.
- Get haircuts for Level 2 assets (for example 15% to Level 2A and 50% for Level 2B as is provided by Basel III).
Calculate Net Cash Outflows (NCO):
- Evaluate expected withdrawals by depositors, existing maturing volume, and other payment commitments during 30 days Stress Testing period.
- Deduce inflows: contractual (loan recovery capped at 75% of total Contractual outflows).
Compute the LCR:
HQL / NCO 100 [%].
LCR targets set are as follows:
- A minimum of 100 % for compliance, signifying that the bank has sufficient liquid asset to meet all probable outflows
- 120 % for a sustained pillar of stability
- 150 % as the supreme target for robust safety measure.
Example Calculation:
- HQLA: Level 1: $400 million; Level 2: $100 million after haircuts; Total consolidated of $500 million.
- Net Cash Outflows: $450 million.
Thus, the cost recovery in the LCR is equal to the ratio $500M/$450M times 100, thus 111%.
FLAWS OF LIQUIDITY COVERAGE RATIO
Despite its importance, the LCR is not without limitations:
Overemphasis on Short-Term Liquidity:
- The LCR concerns itself with a one – month period only and this causes it to miss out on long-term sources of liquidity risk.
Asset Encumbrance:
- When calculating its LCR requirement, a bank may cross such essential items of high quality with other important uses in mind.
Operational Complexity:
- LCR calculation and particularly LCR maintenance is costly and requires much effort at the operational level.
Limited Applicability to Non-Banks:
- Their findings indicate that their model, referred to as LCR, is best suited for banks but it may not solve liquidity risks affecting NBFCs.
Market Dependence:
- Liquidity of HQLA is affected by market conditions and brought volatility to LCR measurements.
LCR Vs. OTHER LIQUIDITY RATIO
While the LCR is a prominent liquidity measure, other ratios serve complementary purposes:
1. Net Stable Funding Ratio (NSFR):
- Focus: Maintains a stable funding profile over the long run by comparing the amount of stable funding available with the amount of funding needed to fund stable assets on a one-year time horizon.
- Comparison: LCR speaks to acute liquidity, while NSFR is directed to embedded liquidity.
2. Loan-to-Deposit Ratio (LDR):
- Focus: It is calculated to determine how much of loans in a specific period of a bank has been funding by deposit.
- Comparison: LDR is comparatively less accurate because it hardly captures all types of resources but is confined to sources of funds.
3. Current Ratio:
- Focus: Applied to calculate a company’s short-term solvency ratio by using the formula, current assets divided by current liabilities.
- Comparison: The current ratio above applies to all businesses while the LCR is specific to banks.
4. Quick Ratio:
- Focus: Comparable to the current ratio but does not include inventory as highly liquid which are likely to convert into cash in the shortest possible time.
- Comparison: It remains a wide ratio, as well as the current ratio, unlike a comparable measure – the Liquidity Coverage Ratio that specifically concerns banks.
THE EFFECTS OF LCR ON BANKS AND ECONOMY
For Banks:
- It reduces the prospects of commercial banks facing liquidity shocks hence improve on the readiness to face liquidity crunch situations.
- Promote sound and optimal management of liquidity and at the same time instills confidence among the investors.
For the Economy:
- Reduces the level of risks associated with systemic institutions.
- Stability in capital markets is encouraged as banks need to be solvent and proof of this has to be shown.
For Regulators:
- Is used as an essential method of supervising financial institutions as well as preventing and controlling risks whenever they are potentially identified.
CONCLUSION
The Liquidity Coverage Ratio (LCR) is one of the greatest building blocks of current banking regulation, improving the stability of the financial system against the short-term liquidity risks.
Admittedly, further implementation aspects may face issues like the operational complications and the excessive focus on first-order risks, but the advantages are far greater than the disadvantages.
Through sound regulation of liquidity risks, the LCR helps build stability in the banking sector – favorable for growth and investment.
Despite this, to address long-term liquidity problems and changes within the financial markets the banks must, however, supplement LCR compliance with other risk management techniques.
FAQs
Q1. What is Liquidity Coverage Ratio (LCR)?
A Liquidity risk profile, which could be tested using the LCR, refers to a bank’s capacity to handle their specific liquidity risks.
It measures the ability of the bank to repay it’s obligations during distressed circumstances while holding adequate cash amounts.
Q2. What do small numbers on the balance sheet mean?
Statutory liquidity ratio refers to a compulsory bench mark undergone in Indian banking regulation which require a Bank to hold a certain percentage of its Net Demand and Time liabilities (NDTL) in form of cash, gold or other securities recognized by the government. SLR, unlike LCR is meant to ensure that banks remain solvent and stable in the long-run.
Q3. What a bank can do to control liquidity risk?
Ways through which banks can cut liquidity risk are as under:
- Maintaining diversified funding base.
- Increase their HQLAs stock.
- Keep regular monitoring and stress test their liquidity positions.
- Rigid policies of risk management.
- Implementation of the LCR and NSFR tools for the management of liquidity risk.
Q4. Who should take 30% drawdown of liquidity facilities?
The 30 percent drawdown requirement refers to stress scenarios where financial institutions expect customers and counterparties to draw down 30 percent of their access credit and liquidity lines.
This helps in maintaining the stability during liquidity crises by the regulatory frameworks of stress tests on banks.
Q5. What is LCR?
LCR or Liquidity Coverage Ratio refers to a new regulation in the banking sector wherein a bank must have an unencumbered pool of high-quality liquid assets which would suffice for covering all short-term needs arising out of a 30-day stress scenario. These reforms under Basel III have a broader aim of making financial institutions stronger.