Liquidity Coverage Ratio: A bank’s life support in the face of crises

While dealing with increased financial distress, banks look to the central bank or the government to come to their rescue. Liquidity Coverage Ratio is the financial shield that protects a bank from an impending bankruptcy

A major fault line that the financial crisis of 2008 exposed in banking sectors worldwide was the improper monitoring of the liquidity risk. A steep fall in the US housing market led to extreme financial stress in the US between mid-2007 and early 2009. Numerous banks worldwide recorded huge losses and relied on central banks to avoid bankruptcy.

Liquidity Coverage Ratio was thus devised to control and monitor the liquidity of financial firms from 2009. Comprehensive measures were undertaken to respond to the global financial crisis, called the “Basel III post-crisis reforms”.

Liquidity Coverage Ratio: what is it?

When the financial crisis hit, many banks worldwide faced a liquidity shock. They didn’t have enough assets that could be converted into cash to avoid defaulting. Liquidity Cover Ratio (LCR) requires a bank to maintain a certain stock of High-Quality Liquid Assets (HQLA) to help it weather a stressful period, like the financial crisis of 2008.

It helps the bank stay afloat during a financial crisis, at least until the government or the central bank can come to its rescue.

Calculating LCR

Here is how we calculate Liquidity Coverage Ratio:

Liquidity Coverage Ratio = (High Quality Liquid Assets) / (Total net cash outflows over the next 30 calendar days)

Every asset that can be easily and instantly converted into cash at minimum or no cost of value is a High-Quality Liquid Asset.

The significance of LCR

As mentioned earlier, the Liquidity Coverage Ratio in banking resulted from the Basel III agreement, which is a series of measures undertaken by the Basel Committee on Bank Supervision (BCBS). This international committee comprises 45 members in 28 jurisdictions across the world.

A pertinent question to ask would be: why keep only 30 days’ worth of high-quality liquid assets? A period of 30 days allows governments or central banks such as the RBI enough time to step in and save the bank from defaulting.

Ratios similar to LCR

You might think that High Quality Liquid Assets that last only 30 days are probably insufficient for a bank weathering a stress period. In some cases, this is true. Another ratio that the Basel III rules mandate is the Net Stable Funding Ratio (NSFR).

Just as Liquidity Coverage Ratio promotes the short-term resilience of banks, the NSFR promotes their resilience over a longer-term. It requires banks to fund their activities with more stable funding sources on an ongoing basis.

NSFR = (Available Stable Funding) (ASF) / (Required Stable Funding) (RSF) ≥ 100

This ratio, just like Liquidity Coverage Ratio, should always be above 100.

Limitations of LCR

LCR ratio being a preventive measure, it is generally beneficial for a bank, especially during a financial crisis. But it has its share of limitations, too. Both LCR and NSFR require banks to hold more cash in terms of assets. Hence, the ability of a bank to disburse loans to companies and individuals reduces. It can further lead to an economic slowdown, hence reducing the capacity of individuals to avail of loans and the ability of businesses to expand.

Disclaimer

The contents of this article/infographic/picture/video are meant solely for information purposes. The contents are generic in nature and for informational purposes only. It is not a substitute for specific advice in your own circumstances. The information is subject to updation, completion, revision, verification and amendment and the same may change materially. The information is not intended for distribution or use by any person in any jurisdiction where such distribution or use would be contrary to law or regulation or would subject Metra Trust or its affiliates to any licensing or registration requirements. Metra Trust shall not be responsible for any direct/indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information mentioned. Please consult your financial advisor before making any financial decision.