What is Liquidity Coverage Ratio (LCR)?
Banks are required to maintain a certain ratio of assets to liabilities. This helps maintain that they can satisfy their short-term obligations in the event of an economic crisis.
To understand what LCR means in banking, you must first understand how it works. The ratio is determined by comparing assets to short-term liabilities. Lenders want to make sure they can meet their obligations quickly and easily. To do so, they check the ratio of short-term to total assets. If it's too low, they need to adjust their strategy.
This is called the liquidity coverage ratio (LCR). Banks use the LCR calculation to determine how much liquidity they should keep at all times. This article will discuss the liquidity coverage ratio, the minimum liquidity coverage ratio and how to interpret it. Continue reading to learn everything you need to know about LCR.
Here’s What We’ll Cover:
What Are Liquidity Coverage Ratios (LCR)?
The LCR is very important as this helps a bank survive during a crisis situation that would otherwise pose a threat to their existence. This will be beneficial to those that use banking facilities as they will have no fears of losing their assets should the bank experience any financial downturns. This ratio is used to determine how much liquidity a bank should actually have on hand given the amount of certain assets and liabilities it has in place, compared to its bond issuances.
The formula for LCR is:
LCR = (Liquid Assets / Total Cash Outflows) X 100
Where liquid assets include cash and readily available assets that are deemed to be convertible into cash within a maximum of five working days. Cash outflows include deposits, interbank loans and bonds which mature within the next 90 days.
The first step in this process is to determine the net cash outflows for a thirty-day time horizon (the number of days in one month). These are calculated by multiplying each day's inflows and outflows together. Then, a bank should add the current market value of all liquid assets that are easily convertible into cash to determine its liquid asset holdings. Once this is done, you will have what is known as the LCR numerator.
The next step in liquid coverage calculation is determining each bank's liquid liabilities. These are calculated by multiplying all deposits and the current market value of all bonds issued by a bank. This is added to each bank's net cash outflows from the previous step to arrive at a LCR denominator. The resulting number represents the minimum amount of liquidity that a bank should have.
What Are Liquid Assets?
Liquid assets refer to any asset that can be turned into cash immediately. This includes all current accounts, savings accounts and other bank balances. The value of liquid assets will be input into the LCR formula.
What are Cash Outflows?
Cash outflows are anything that reduces the amount of cash available to a bank. These would include short-term borrowing, interbank loans, overdrafts and maturing securities.
What Is the Minimum Liquidity Coverage Ratio?
A liquidity coverage ratio should be at least 100% or 1:1. If it were lower than this, it would mean that the bank is not meeting the minimum liquidity standards and this could create a potential safety and soundness issue.
How to Interpret Liquidity Coverage Ratio
When the ratio is greater than 100%, it means that a bank is financially healthy. However, if the ratio is below 1:1, this shows that the bank might not have enough liquidity to cover its short term obligations or pay for its daily operations.
The LCR has been proposed to be included in the Basel III framework. The LCR proposal was brought about as a result of the financial crisis that occurred in 2008 as a means to improve liquidity over the next few years.
What Is a Good LCR?
Experts say that a bank should have an LCR ratio of 1:1, but this is difficult to achieve and set as it requires a bank to keep enough liquid assets or cash at any one time for the next thirty days. As such, the Financial Stability Board (FSB) recommends having a liquidity coverage ratio of 100%.
What Is NSFR?
NSFR stands for Net Stable Funding Ratio. NSFR is a capital requirement of banks that helps promote two key objectives of the Basel III framework. The first objective is to maintain a stable growth of the liquidity risk of an institution. This is done by ensuring that a bank has a high-quality liquid asset available at any given time during times when there are extreme market conditions or financial market stress.
The second objective of NSFR is to ensure that a bank has enough stable sources of funding which can be used as the basis for more credit. To meet this requirement, banks must manage their liquidity and long-term assets in such a way as to keep them separate from their long-term and short-term liabilities and commitments.
How does LCR compare to NSFR?
NSFR and the LCR are both capital requirements that a bank must meet in order to be deemed stable. However, they serve different purposes. The LCR is a liquidity requirement while NSFR is a funding requirement.
In addition, the LCR only focuses on thirty days of liquidity coverage while NSFR focuses on long-term liquidity management.
What Is the Proposed Basel III Ratio?
Banks need to hold enough liquid assets to cover their short term liabilities for thirty days. However, some financial experts argue that this should actually be closer to ninety or one hundred and twenty days.
The proposed ratio of 90 days brings more stability than the LCR. This would require banks to hold enough assets for the next ninety days instead of just thirty. A ratio of 1-1.2 would be even more conservative than that. This is not likely to be adopted by regulators anytime soon.
Liquidity coverage ratio (LCR) is a measure of how much cash or liquid assets banks should have. The LCR has been proposed to be included in the Basel III framework. This helps promote stability for financial markets and institutions. It provides liquidity resources during times of crisis. Central bank regulators are currently discussing what an appropriate minimum level would be. Experts suggest that it should actually be closer to 90-120 days. This would be instead of the 30 days as set out in the current proposal. This provides more stability than just having 100% liquidity coverage. There will always be some type of withdrawal happening even when you're at peace with your customers.
LCR is an important measurement. Hopefully, this article gives you a great understanding of how LCR works and why it's important.
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