Liquidity Coverage Ratio

Liquidity Coverage Ratio (LCR)

The Liquidity Coverage Ratio (LCR) is a regulatory liquidity ratio that measures a bank’s ability to meet its cash outflows over a 30-day period under severe stress conditions. The LCR is calculated by dividing the bank’s high-quality liquid assets (HQLA) by its expected net cash outflows over the 30-day period.

The LCR was introduced by the Basel Committee on Banking Supervision in 2010 in response to the financial crisis of 2007-2008. The LCR is designed to ensure that banks have enough liquid assets to meet their short-term obligations even if there is a disruption to the financial markets.

The LCR is calculated as follows:

LCR = HQLA / Expected net cash outflows over 30 days
  • HQLA: High-quality liquid assets are assets that are easily converted into cash and are unlikely to lose value in a stressed market. Examples of HQLA include cash, central bank reserves, and government bonds.
  • Expected net cash outflows over 30 days: Expected net cash outflows are the amount of cash that a bank expects to pay out over a 30-day period. This amount is calculated by taking into account the bank’s expected deposit withdrawals, loan repayments, and other cash outflows.

The LCR must be at least 100%. This means that banks must have enough HQLA to cover their expected net cash outflows for at least 30 days.

MCQs on Liquidity Coverage Ratio

  1. Which of the following is NOT a high-quality liquid asset (HQLA)?
    • Cash
    • Central bank reserves
    • Government bonds
    • Commercial paper
    • The correct answer is commercial paper. Commercial paper is not a HQLA because it is not issued by a government or central bank.
  2. Which of the following is the most important factor in determining a bank’s LCR?
    • The amount of HQLA the bank holds
    • The amount of expected net cash outflows the bank has
    • The length of the time horizon (30 days)
    • All of the above
    • The correct answer is all of the above. The LCR is determined by the amount of HQLA the bank holds, the amount of expected net cash outflows the bank has, and the length of the time horizon (30 days). All of these factors are important in determining a bank’s LCR.
  3. Which of the following is the most challenging aspect of complying with the LCR?
    • Calculating the expected net cash outflows
    • Holding enough HQLA
    • Monitoring the LCR on a daily basis
    • All of the above
    • The correct answer is all of the above. Calculating the expected net cash outflows can be challenging, especially in a stressed market. Holding enough HQLA can also be challenging, especially for smaller banks. Monitoring the LCR on a daily basis can also be challenging, especially for banks with a lot of activity.

Conclusion

The Liquidity Coverage Ratio (LCR) is an important regulatory liquidity ratio that measures a bank’s ability to meet its cash outflows over a 30-day period under severe stress conditions. The LCR is designed to ensure that banks have enough liquid assets to meet their short-term obligations even if there is a disruption to the financial markets.