What is LCR (Liquidity Coverage Ratio)?
Liquidity Coverage Ratio (LCR) refers to the amount of liquid assets banks are required to keep as coverage in order to have sufficient reserves on hand in the event of a financial crisis.
More specifically, the Liquidity Coverage Ratio is defined as the percentage amount of cash, cash equivalents, or short-term securities that large banks are required to hold as reserves to meet their short-term financial obligations during a crisis event.
The LCR is calculated by dividing a financial institution’s most liquid assets by its cash outflows over a 30-day period.
If a bank has High Quality Liquid Assets (HQLA) worth $100 million and its projected cash outflows for a 30-day stress period is $50 million, then its LCR is said to be 200%.
LCRs apply to banks and nonbank financial institutions, such as insurance companies, finance companies, real estate investment trusts, etc. But they are especially important for systemically important institutions, such as large banks and financial institutions that hold large amounts of capital and are critical to the global economy’s functioning.
Liquidity Coverage Ratio Requirements
The concept and requirements of LCR were devised by the Basel Committee of Banking Supervision in 2009 as a response to the 2008 financial crisis, which was caused by banks issuing risky loans and other egregious banking activities.
Such behavior resulted in losses at banks and insurance companies and investors began withdrawing their funds from these institutions. Some filed for bankruptcy and were bailed out by the federal government. The losses at some of the other institutions were so severe that they had to shut down. The liquidity coverage ratio was seen as a solution to prevent future recurrences of similar scenarios. The Group of Central Bank Governors and Heads of Supervision, an oversight body for the Basel Committee on Banking Supervision, has stated that “the aim of the Liquidity Coverage Ratio is to ensure banks, in normal times, have a sound financial structure and hold sufficient liquid assets such that central banks are asked to perform as lenders of last resort and not as lenders of first resort.”
As of 2019, large banks were required to have an LCR of 100%, meaning they should have sufficient liquid assets to cover 100% of their cash outflows for at least 30 days. The requirement has been phased-in gradually since 2015.
Large banks, in this context, refers to banks that meet either one of the following criteria:
- They have $250 billion or more in total consolidated assets
- They have $10 billion or more in on-balance sheet foreign exposure and their subsidiaries, which have $10 billion or more in assets.
The Federal Reserve and banks’ own senior management conduct periodic stress tests in order to ensure compliance with LCR requirements.
How is Liquidity Coverage Ratio Calculated?
The formula to calculate LCR is:
LCR = High Quality Asset Amount (HQLA)/Total Net Cash Flow Amount
HQLA = assets that can be easily converted to cash.
Net cash flow = the financial institution’s estimated cash flow during a 30-day stress period.
The net cash flow can be calculated as the difference between cash outflows, or the outstanding balances in various categories of liabilities and commitments at their respective interest rates, minus expected inflows during a stress period.
For example, if a bank has high quality liquid assets worth $150 million and its projected cash outflows for a 30-day stress period is $100 million, then its LCR is said to be 150 percent.
Three levels of assets are defined as high-quality assets. They are:
- Level 1 assets which include,
- Federal Reserve bank balances
- Easily withdrawn foreign resources
- Securities issued or guaranteed by the US government or other sovereign entities
- Level 2A which include,
- Securities issued by certain multilateral development bank or sovereign entities
- Securities issued by US government sponsored enterprises
- Level 2B assets which include,
- Publicly traded common stock
- Investment grade debt securities issued by institutions outside the financial sector
A bank can hold an unlimited amount of Level 1 assets but the number of Level 2A assets is capped at 40%, according to the original Basel Accord document.
Criticisms of Leverage Coverage Ratio
Critics of LCRs point to two major flaws with the concept.
The first one is that LCR requirements can inhibit banks from lending money they are required to keep on hand to deal with a financial crisis that may or may not occur in the future. This can result in losses for the bank. For example, consider the case of a bank that has a total projected cash outflow of $100 million. This figure is a fairly liberal estimate of outflows during a financial crisis that the bank arrived at by taking into consideration all possible scenarios. If the bank fails to meet its reserve requirements, then it will have to pay premium rates to access the Fed’s lending window. If, however, the reserve requirements are in excess of the required amount to weather a financial crisis, then the bank incurs an opportunity cost by not putting that money to work as loans.
The second problem with the LCR concept is that reserve requirements may not be sufficient (or, they may be in excess) for another crisis. The scope and severity of each financial crisis is different. In turn, this means that it is difficult to predict their impact on the financial sector with certainty. For example, the recession caused by the Covid-19 pandemic was much more widespread than the one caused by the 2008 financial crisis. While the Federal Reserve’s reaction to both crises was similar in some respects, it was also different because the agency deepened the extent of its intervention in the economy by sending out direct payments to citizens during the pandemic shutdown. How these financial crises affect liquidity coverage ratio values in the future is still to be determined.