The liquidity coverage ratio (LCR) is in essence a common anxiety test that aims to anticipate market-wide shocks and make sure that financial institutions possess suitable capital conservation, to ride out any short-term liquidity interferences that may infect the market.
In this article, we’ll dive deeper into what exactly that means, how it is calculated, and what the limitations are.
What Is the Liquidity Coverage Ratio?
The liquidity coverage ratio (LCR) refers to the percentage of extremely liquid assets apprehended by financial establishments to make sure they sustain a continuing capability to meet their short-term compulsions – cash discharges for 30 days. 30 days was carefully chosen because, in a financial catastrophe, a reaction from governments and central banks would characteristically take around 30 days.
Specifically, the liquidity coverage ratio is a pressure test that is proposed to ensure banks and financial institutions have an adequate level of assets to ride out short-term interruptions to liquidity. This spreads over to banks with over $500 billion in total merged assets or banks with over $20 billion in on-balance sheet foreign exposure.
Understanding LCR and the Basel Accord
The liquidity coverage ratio (LCR) is a principal take away from the Basel Accord, a chain of principles established by The Basel Committee on Banking Supervision (BCBS). The BCBS is a collection of 45 representatives from the most important universal financial centers.
One of the major objectives of the BCBS was to order banks to embrace a precise level of highly liquid assets and sustain definite stages of fiscal solvency to depress them from loaning high levels of short-term dues.
Thus, banks are mandatory to embrace an amount of high-quality liquid assets that are sufficient to fund cash outflows for 30 days. High-quality liquid assets comprise only those with a high possibility to be transformed effortlessly and swiftly to cash.
How to Calculate the Liquidity Coverage Ratio
The simple formula for calculating the LCR ratio is:
LCR = High-Quality Liquid Asset Amount (HQLA) / Total Net Cash Flow Amount
Therefore, to calculate the LCR, divide the bank’s high-quality liquid assets by the total net cash flows throughout a specific 30-day stress period.
What Is the Difference Between LCR and Other Liquidity Ratios?
The liquidity coverage ratio is the prerequisite with which banks must hold an amount of high-quality liquid assets that are sufficient to fund cash outflows for 30 days. Liquidity ratios are similar to the LCR inasmuch as they measure a company’s capability to meet its short-term financial compulsions.
Liquidity ratios are a class of financial metrics used to define a company’s ability to pay off existing debt obligations without raising external capital.
What Are the Limitations of the Liquidity Coverage Ratio?
There are significant limitations associated with LCR (liquidity coverage ratio).
First, LCR requires banks to hold on to more cash. Subsequently, fewer loans could be allotted to businesses or consumers. It is also important to remember that it is impossible to know whether the LCR ratio makes a strong financial cushion available for banks pending when the next financial crisis happens, and at that point, the damage would have been done.
LCR is aimed to certify that banks hold an adequate reserve of High-Quality Liquid Assets (HQLA) to enable them to survive a period of momentous liquidity stress lasting for 30 calendar days. The 30-calendar-day stress period is the minutest period that is necessary for remedial action to be taken by the management of the bank or the supervisors.