The liquidity coverage ratio (LCR) refers to highly liquid assets held by financial institutions to meet short-term obligations. The ratio is a generic stress test that aims to anticipate market-wide shocks. The LCR assures that financial institutions have the necessary assets on hand to ride out any short-term liquidity disruptions.
BREAKING DOWN 'Liquidity Coverage Ratio - LCR'
The liquidity coverage ratio applies to all banking institutions that have more than $250 billion in total consolidated assets or more than $10 billion in on-balance sheet foreign exposure. Banks are required to have a 100% LCR, which means holding an amount of highly liquid assets that are equal to or greater than its net cash flow over a 30-day stress period. Highly liquid assets can include cash, Treasury bonds or corporate debt.
The LCR was implemented and measured in 2011, but the full 100% minimum was not enforced until 2015. The liquidity coverage ratio is an important part of the Basel Accord, defining how the value of liquid assets that are required to be held by financial institutions. The idea is that by requiring banks to hold a certain level of highly liquid assets, they are less able to lend high levels of short-term debt.
High-Quality Liquid Assets for the Liquidity Coverage Ratio
The high-quality liquid assets include only those with a high potential to be converted easily and quickly into cash. There are three categories of high-quality liquidity assets with decreasing levels of quality: level 1, level 2A and level 2B assets.
Under Basel III, level 1 assets are not discounted when calculating the LCR, while level 2A and level 2B assets have a 15% and 50% discount, respectively. Level 1 assets include Federal Reserve bank balances, foreign resources that can be withdrawn quickly, securities issued or guaranteed by specific sovereign entities, and U.S. government issued or guaranteed securities.
Level 2A assets include securities issued or guaranteed by specific multilateral development banks or sovereign entities, and securities issued by U.S. government-sponsored enterprises. Level 2B assets include publicly traded common stock and investment-grade corporate debt securities issued by non-financial sector corporations.
Liquidity Coverage Ratio Calculation Example
The LCR is calculated by dividing a bank's high-quality liquid assets by its total net cash flows over a 30-day stress period. Assume bank ABC has high-quality liquid assets worth $55 million and $35 million in anticipated net cash flows over a 30-day stress period. Therefore, bank ABC has an LCR of 1.57, or 157%, which meets the requirement under Basel III.
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