Computing the LCR

Computing the LCR

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The LCR, or liquidity coverage ratio, was projected in 2010, underwent revisions, and was finally approved in 2014. 2019 was the first year that the full 100% minimum was required. All banks that have on-balance sheet foreign exposures of more than $10 billion or total consolidated assets of more than $250 billion are subject to the liquidity coverage ratio. Over a 30-day stress period, these banks—often referred to as SIFI—are required to maintain a 100% LCR, which entails holding highly liquid assets equal to or greater than their net cash flow. Cash, Treasury bonds, and corporate debt are examples of highly liquid assets.

Comparing LCR to Other Liquidity Ratios - Liquidity ratios are a group of financial metrics that are used to figure out a company's capacity to pay off its current debt obligations without raising capital from outside sources. Using metrics like the current ratio, quick ratio, and operating cash flow ratio, liquidity ratios calculate a company's ability to pay its debts and its margin of safety. In an emergency, the coverage of short-term debts is evaluated by comparing current liabilities to liquid assets. Banks are required to hold a sufficient amount of high-quality liquid assets, known as the liquidity coverage ratio, to cover cash outflows for a period of thirty days. In that they measure a company's capacity to meet its short-term financial obligations, liquidity ratios are comparable to the LCR.

Calculating the LCR s - LCR is calculated by dividing a bank's high-quality liquid assets by its total net cash flows over a 30-day stress period. HQLA stands for the amount of high-quality liquid assets divided by total net cash flows. Only those assets that have a high likelihood of being quickly and easily converted into cash are included in the high-quality liquid assets. Let's say that bank ABC has high-quality liquid assets worth $55 million and $35 million in anticipated net cash flows over a 30-day stress period: These are the three categories of liquid assets whose quality decreases.

$55 million divided by $35 million constitutes the LCR.

The LCR of Bank ABC is 1.57, or 157%, which satisfies the Basel III requirement.

Disadvantages of the LCR - One of the LCR's limitations is that it necessitates banks to hold more cash, which may result in fewer loans being granted to businesses and consumers. It could be argued that businesses that require debt to fund their operations and expansion would not have access to capital if banks issued fewer loans, which would result in slower economic growth. However, we won't know until the next financial crisis whether the LCR provides banks with a sufficient financial cushion or is insufficient to fund cash outflows for 30 days. The LCR is a stress test designed to ensure that financial institutions have adequate capital in the event of short-term disruptions in liquidity.