Components and Conditions of LCR or, the Liquidity Coverage Ratio

Components and Conditions of LCR or, the Liquidity Coverage Ratio

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The proportion of highly liquid assets held by financial institutions to guarantee their ongoing capacity to meet short-term obligations is referred to as the LCR or, the liquidity coverage ratio. This ratio is basically a general stress test with the goal of anticipating shocks that could affect the entire market and ensuring that financial institutions have adequate capital preservation to withstand any short-term liquidity disruptions that could occur in the market. In accordance with Basel III, banks are required to hold an amount of high-quality liquid assets sufficient to fund cash outflows for thirty days. This requirement is known as the LCR. The LCR is a stress test designed to anticipate market-wide shocks and ensure that financial institutions have sufficient capital preservation to withstand any short-term disruptions in liquidity.

Naturally, we won't know until the next financial crisis whether the LCR gives banks enough of a financial cushion or not. A major takeaway from the Basel Accord, which is a set of rules created by The Basel Committee on Banking Supervision (BCBS), is the Liquidity Coverage Ratio (LCR). A group of 45 people from major global financial centers make up the BCBS. In order to prevent banks from lending excessive amounts of short-term debt, one of the objectives of the BCBS was to mandate that they hold a certain amount of assets that are highly liquid and sustain a certain level of fiscal solvency.

Consequently, banks must maintain sufficient high-quality liquid assets to fund cash outflows for 30 days. Only assets with a high likelihood of being quickly and easily converted into cash are considered to be high-quality liquid assets. Level 1, Level 2A, and Level 2B are the three categories of liquid assets with decreasing quality. The duration of thirty days was chosen because it was anticipated that governments and central banks would typically respond to a financial crisis within thirty days. To put it another way, banks are provided with a cushion of cash over the 30-day period in the event of a bank run during a financial crisis. The LCR's 30-day deadline also gives central banks like the Federal Reserve Bank time to intervene and put corrective measures into place to stabilize the financial system.

Level 1 assets are not discounted when calculating the LCR under Basel III, whereas level 2A and level 2B assets are discounted by 15% and 25-50%, respectively. Level 1 assets include bank balances, quickly withdrawable foreign resources, securities issued or guaranteed by specific sovereign entities, and securities issued or guaranteed by the United States government.