3 mins read
29-Aug-2024
The liquidity coverage ratio is the proportion of extremely liquid assets that banks and financial institutions maintain to ensure they can take care of any immediate or short-term financial needs and obligations, typically covering for at least 30 days.
The liquidity coverage ratio acts as a lifeline for a bank when it is faced with a crisis or unfortunate event. This concept was introduced after the 2008 crisis, which had a great impact on the world economy.
In this article, we will learn what liquidity coverage ratio is, the liquidity coverage ratio formula, how it is calculated, and some of its limitations.
An international banking agreement called the Basel Accords mandated a fixed and standard liquidity coverage ratio after the 2008 financial crisis, which saw banks collapse due to irregularities. This measure ensures that banks can stay afloat during times of financial stress and buys them some time before the government or central banks can intervene to help them salvage the situation.
The liquidity coverage ratio demands that a bank hold high-quality liquid assets that match or exceed 100% of their anticipated cash outflows in a stress scenario.
This committee consisted of representatives from 45 global financial power centres. They aimed to set certain standards that would help maintain solvency for banking institutions worldwide and help them face financial storms and unfortunate economic situations.
In their recommendations, they suggested that banks should have enough proportion of high-quality liquid assets to fund any anticipated cash flow for the next 30 days.
The HQLAs were supposed to be financial instruments that could be easily converted to cash, like short-term government debt. These HQLAs were classified into three categories in decreasing order of liquidity quality: Level 1, Level 2A, and Level 2B.
Under Basel III standards, Level 1 assets are fully recognised without any discount in the calculation of the liquidity coverage ratio. Conversely, Level 2A and Level 2B assets face discounts of 15% and between 25% and 50%, respectively.
Level 2A assets include securities issued or supported by specific multilateral development banks, the Government of India, or Indian government-affiliated organisations.
Level 2B assets feature publicly traded equity shares and investment-grade corporate bonds issued by non financial companies based in India.
A time period of 30 days was suggested since, in the face of a serious financial meltdown, this time frame would provide sufficient time for Central Banks of various countries to intervene, rescue, and help add stability to the banking system.
Simply put, the liquidity coverage ratio is supposed to act like a stress test for banks to make sure they have the required amount of capital to survive any short-term financial storms.
Liquidity coverage ratio = Amount of High-Quality Liquid Asset (HQLA) / Total of the net cash flow amount
If you want to calculate the liquidity coverage ratio of a banking or financial institution, first calculate the HQLAs or high-quality liquid assets of the bank and then divide it by the total net cash flows over the 30-day stress period.
LCR = High-quality liquid asset amount (HQLA)/Total net cash flow amount
LCR = Rs. 400 Crore/Rs. 250 Crore = 160%
In the above scenario, the LCR of XYZ bank is 160%, which meets the requirements stated by the Basel III Accords.
According to the accord, the implementation of LCR by banks was to be done in a phased-out manner, and they were expected to implement 100% by 2019.
Banks that have more than Rs. 25,000 Crores of total consolidated assets and more than Rs. 1,000 Crores in on-balance sheet foreign exposure are required to implement and follow all the rules stated by the Basel Accord.
The liquidity coverage ratio mandates banks to always hold onto a significant amount of cash. As a result, they can disburse fewer loans to customers or businesses. This, in turn, leads to reduced spending as customers will not buy more homes, cars, appliances, etc., due to the unavailability of loans. Similarly, businesses might invest less in expanding their operations due to the reduced availability of debt from banks. This could lead to reduced profits for banks since they cannot earn from loans, and it might also lead to an overall slowdown in economic growth.
Another shortcoming is that we do not know how effective the liquidity coverage ratio is in helping a bank or financial institution weather a financial storm. The full scale of its usefulness can only be gauged if it is put to the test during a financial crisis.
For deeper insights, here are additional articles that are closely aligned with your interests:
Similar to LCR, Basel III also recommends another ratio called the Net Stable Funding Ratio (NSFR), which also aims to promote the short-term ability of the bank to meet its obligations through stable funding instruments.
NSFR = Available stable funding of the bank / Required stable funding of the bank
As you manage your financial journey, consider exploring diverse mutual fund investment opportunities to boost your financial health. Discover how the Bajaj Finserv Mutual Fund Platform can provide you with a well-rounded investment strategy, helping you select the right mutual fund scheme and achieve your financial goals.
The liquidity coverage ratio acts as a lifeline for a bank when it is faced with a crisis or unfortunate event. This concept was introduced after the 2008 crisis, which had a great impact on the world economy.
In this article, we will learn what liquidity coverage ratio is, the liquidity coverage ratio formula, how it is calculated, and some of its limitations.
What is the Liquidity Coverage Ratio (LCR)?
The liquidity coverage ratio denotes the proportion or percentage of High-Quality Liquid Assets (HQLA) that a banking institution or financial house must mandatorily maintain to easily pay for or fulfil any short-term obligations.An international banking agreement called the Basel Accords mandated a fixed and standard liquidity coverage ratio after the 2008 financial crisis, which saw banks collapse due to irregularities. This measure ensures that banks can stay afloat during times of financial stress and buys them some time before the government or central banks can intervene to help them salvage the situation.
The liquidity coverage ratio demands that a bank hold high-quality liquid assets that match or exceed 100% of their anticipated cash outflows in a stress scenario.
How does the Liquidity Coverage Ratio Work?
The concept of having a compulsory liquidity coverage ratio was suggested by the Basel Accords drafted by the Basel Committee on Banking Supervision (BCBS).This committee consisted of representatives from 45 global financial power centres. They aimed to set certain standards that would help maintain solvency for banking institutions worldwide and help them face financial storms and unfortunate economic situations.
In their recommendations, they suggested that banks should have enough proportion of high-quality liquid assets to fund any anticipated cash flow for the next 30 days.
The HQLAs were supposed to be financial instruments that could be easily converted to cash, like short-term government debt. These HQLAs were classified into three categories in decreasing order of liquidity quality: Level 1, Level 2A, and Level 2B.
Under Basel III standards, Level 1 assets are fully recognised without any discount in the calculation of the liquidity coverage ratio. Conversely, Level 2A and Level 2B assets face discounts of 15% and between 25% and 50%, respectively.
For Indian banks
Level 1 assets encompass deposits with the Reserve Bank of India (RBI), highly liquid foreign assets, securities issued or backed by the Government of India, and securities guaranteed by other sovereign bodies.Level 2A assets include securities issued or supported by specific multilateral development banks, the Government of India, or Indian government-affiliated organisations.
Level 2B assets feature publicly traded equity shares and investment-grade corporate bonds issued by non financial companies based in India.
A time period of 30 days was suggested since, in the face of a serious financial meltdown, this time frame would provide sufficient time for Central Banks of various countries to intervene, rescue, and help add stability to the banking system.
Simply put, the liquidity coverage ratio is supposed to act like a stress test for banks to make sure they have the required amount of capital to survive any short-term financial storms.
LCR formula
To calculate the liquidity coverage ratio, a simple formula needs to be applied:Liquidity coverage ratio = Amount of High-Quality Liquid Asset (HQLA) / Total of the net cash flow amount
If you want to calculate the liquidity coverage ratio of a banking or financial institution, first calculate the HQLAs or high-quality liquid assets of the bank and then divide it by the total net cash flows over the 30-day stress period.
How to calculate the LCR?
To understand the calculation of LCR, let us take the example of XYZ bank, which has Rs. 400 Crore worth of high-quality liquid assets. Its cash obligations to meet the short-term demands of the 30-day stress period amount to Rs. 250 Crore.LCR = High-quality liquid asset amount (HQLA)/Total net cash flow amount
LCR = Rs. 400 Crore/Rs. 250 Crore = 160%
In the above scenario, the LCR of XYZ bank is 160%, which meets the requirements stated by the Basel III Accords.
Implementation of the LCR
The rule to implement a liquidity coverage ratio was first proposed in the year 2010. This was followed by multiple reviews, and the final draft was approved in 2014.According to the accord, the implementation of LCR by banks was to be done in a phased-out manner, and they were expected to implement 100% by 2019.
Banks that have more than Rs. 25,000 Crores of total consolidated assets and more than Rs. 1,000 Crores in on-balance sheet foreign exposure are required to implement and follow all the rules stated by the Basel Accord.
Limitations of the Liquidity Coverage Ratio
Although the LCR ratio is extremely important to safeguard banks during times of financial crisis, it comes with its share of limitations.The liquidity coverage ratio mandates banks to always hold onto a significant amount of cash. As a result, they can disburse fewer loans to customers or businesses. This, in turn, leads to reduced spending as customers will not buy more homes, cars, appliances, etc., due to the unavailability of loans. Similarly, businesses might invest less in expanding their operations due to the reduced availability of debt from banks. This could lead to reduced profits for banks since they cannot earn from loans, and it might also lead to an overall slowdown in economic growth.
Another shortcoming is that we do not know how effective the liquidity coverage ratio is in helping a bank or financial institution weather a financial storm. The full scale of its usefulness can only be gauged if it is put to the test during a financial crisis.
For deeper insights, here are additional articles that are closely aligned with your interests:
LCR vs other liquidity ratios
Different types of liquidity ratios are used by governments, investors, banks, and finance professionals to understand and gauge economic performance. Some of these ratios are the current ratio, operating cash flow ratio, and quick ratio.Similar to LCR, Basel III also recommends another ratio called the Net Stable Funding Ratio (NSFR), which also aims to promote the short-term ability of the bank to meet its obligations through stable funding instruments.
NSFR = Available stable funding of the bank / Required stable funding of the bank
Key takeaways
- The liquidity coverage ratio, which was mandated by the Basel III Accords, requires banks to hold onto enough high-quality liquid assets that can be easily converted to cash to cover any financial obligations that arise for the next 30 days.
- The LCR is devised to proactively absorb any extreme fluctuations in the markets and ensure financial markets do not succumb to any financial crisis.
- LCR has yet to prove its effectiveness, as the full extent of its usefulness can only be measured during a financial crisis.
Conclusion
The liquidity coverage ratio is used as a measure to optimise the ability of financial institutions to survive the economic crisis by maintaining enough high-quality liquid assets. This regulatory measure aims to promote financial stability, mitigate liquidity risk, and prevent the kind of crises that have historically threatened the global banking system.As you manage your financial journey, consider exploring diverse mutual fund investment opportunities to boost your financial health. Discover how the Bajaj Finserv Mutual Fund Platform can provide you with a well-rounded investment strategy, helping you select the right mutual fund scheme and achieve your financial goals.
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