Finance

Liquidity Coverage Ratio (LCR)

LiquidityLiquidity Coverage Ratio (LCR)

After the global financial crisis, the prudential supervision of banks has changed drastically. Although the Basel III reforms on the quantity and quality of bank capital have been the most popular, a variety of other policy measures have also been undertaken with the goal of making banks secure and preventing potential crises.

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What is Liquidity Coverage Ratio (LCR)?

The liquidity coverage ratio is a requirement under Basel III  for banks and financial institutions to hold enough High-Quality Liquid Assets (HQLA) – such as short-term government debt to meet the short term obligation that can be sold to fund banks during a 30-day stress scenario designed by regulators. In simple terms, Liquidity Coverage Ratio means the necessary assets that the bank and financial institution should keep on hand to convert it into cash when every necessary to meet its debts. This standard requires that for the next 30 days, the ratio of high-quality financial assets to overall net capital outflow is greater than or equal to 100%.

History and Implementation of Liquidity Coverage Ratio (LCR):

Liquidity Coverage Ratio came into existent after the Great Financial Crisis of 2008. Failure to properly monitor and regulate the liquidity risk created difficulties for a number of financial firms in 2008 and the years that followed and was a major cause of this crisis. In the year 2008 the housing market collapsed, resulting in a large distraction in the market, banks suffered severe funding problems, due to which the short-term lending dried up almost overnight and lenders were afraid about the credit risk. In 2010 the UK Financial Services Authority (FSA) introduced a new liquidity regulation called the Individual Liquidity Guidance (ILG) and in the year 2013 Basel Committee on Banking Supervision introduced the Liquidity Coverage Ratio, which is similar in design to the ILG. The main reason for this regulation was to make the banking system resilient to liquidity disruptions and stress scenarios by requiring banks to keep a minimum quantity of High-Quality Liquid Assets (HOLA). In India, the Liquidity Coverage Ratio was implemented on January 1, 2015, by the Reserve Bank of India (RBI). In the year 2015 RBI has made mandatory to keep LCR to 60%  and rising by 10% point annually to reach 100%  in the year 2019.

Formula and example:

The formula of LCR is:

LCR

Here, HQLA means these are the assets that are cash or near to cash item which can be easily converted into the market in terms of any need. Total net cash outflow over the next 30 days means the excess of total inflows over the total outflow under stressed situation as defined by Basel and RBI.

Let say for example that:

HQLA of the bank is 97400 Cr.

The total outflow is 90250 Cr.

Total inflow is 34100 Cr.

Therefore, the total net outflow of the bank = 90250-34100 = 56150

LCR =  97400 / 56150 * 100

LCR = 173.46 or 1.73

This means that as RBI told to maintain 100% LCR from 2019 so we can say that this bank is maintaining higher than the requirement.

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Benefits of the LCR:

  • The LCR encourages covered banks to reduce their liquidity gaps by reducing their balance sheets’ illiquid asset and liquid liabilities shares.
  • The banking sector as a whole could therefore generate less liquidity, given the highest historic liquidity that has been generated by the major US banks implementing LCR (Berger and Bouwman -2009).
  • The price impact of fire-sells, however, can also be minimized by reduced holdings of illiquid assets (such as loans) shared by LCR banks (Allen and Gale -2004).
  • Consequently, as intended by the LCRR, banks are likely to become more resilient in the short term.

Limitations of LCR:

  • It only includes the high quality liquid assets and does not take into consideration short term security which banks and financial institution trade to meet their short term funding.
  • It is implemented to the banks with more than $250 billion of assets and institutions with at least $10 billion in foreign banking assets, and subsidiaries of those large banks with at least $10 billion in assets. Banks with assets between $50 billion and $250 billion will be subject to a less-stringent LCR.
  • And another limitation is that it needs to use monitoring tools developed by the BCBS to supplement the LCR.
  • The downside of the LCR is that it allows banks to keep more cash which could result in fewer loans to customers and companies.

Although requiring a 100% Liquidity Coverage Ratio guarantees that banks have enough money on hand in the case of a downturn, it also prohibits banks from lending the money they need to hold on hand.

Author: Charmi Mehta

About the Author: Charmi Mehta is currently pursuing an MBA with a specialization in Finance from the Department of Business Administration, Bhavnagar. Charmi is very much interested to work with data and its analysis and she is also fascinated by the financial market.

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