Summary:
Banks,
across the globe, have to maintain liquidity coverage ratio (LCR) as part of the
Basel III norms. These norms are prescribed by the Bank for International
Settlements. BIS a global body that acts as a bank for central banks.
Liquidity
coverage ratio is the proportion of highly liquid assets that a bank should
maintain to meet its liquidity needs in a 30-calendar day period. The LCR is
calculated as a ratio of high-quality liquid assets to the total net cash outflows over the next 30 calendar days.
The
LCR enables a bank to withstand any financial shocks, such as a run on its
deposits, a credit rating downgrade or derivative-linked shocks. These global
norms are being introduced effective 1st of January, 2015 (see table
above).
The
2007/2008 global financial crisis forced central banks to adopt more stringent
liquidity requirements—in the form of the liquidity coverage ratio and net
stable funding ratio—to manage liquidity risk in a better manner.
Let
us discuss the background and more details of this liquidity coverage ratio.
Background:
During
the 2007/2008 global financial crisis, banks and other financial institutions
mismanaged their liquidity requirements. The collapse of Lehman Brothers drove
home the importance of liquidity in the banking system. Banks could not
liquidate their assets, leading to severe stress in the money markets.
Liquidity
risk arises when securities cannot be purchased or sold without a significant
loss in value. This risk is most acute in periods of unusually high market
stress as happened during the global financial crisis.
With
a view to managing such liquidity risks, the Basel Committee on Banking
Supervision (BCBS) has introduced new measures, including the liquidity
coverage ratio (LCR) and the net stable funding ratio (NSFR). The NSFR requires
banks to fund their assets with more stable sources of funding—providing
sustainable maturity structure of assets and liabilities over long term.
What is the need for an
LCR?
Once LCR is implemented, banks will be in a better position to
meet short-term emergency liquidity (cash) needs. The LCR bolsters a bank’s
ability to withstand any financial and/or economic shocks in the short term. It
will also reduce the risk of spillover from the financial sector to the real
economy.
The Liquidity Coverage Ratio is a key component of
the Basel III framework. Basel III norms are global regulatory standards on
bank capital adequacy and liquidity endorsed by the G20 Leaders.
The
LCR enhances the short-term resilience of banks to potential liquidity
disruptions by ensuring that they have sufficient high-quality liquid assets to
survive an acute stress scenario lasting for 30 days.
The
stress scenarios may include: a run on the bank
deposits; a bank losing its ability to raise unsecured funds; a credit rating downgrade;
market-related stress and derivative-linked shocks.
How
to Calculate the LCR?
As
mentioned above, the liquidity coverage ratio is the proportion of highly
liquid assets that a bank should maintain to meet its liquidity needs in a
30-calendar day period. The LCR is calculated as a ratio of high-quality liquid
assets to the total net cash outflows
over the next 30 calendar days.
The LCR has two components: the value of the stock of
high-quality liquid assets (HQLAs) and total net cash outflows.
LCR =
Stock of HQLA / Total net cash outflows over the next 30 calendar days
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The LCR should be equal to or greater
than 100 percent.
Banks, across the globe, have to maintain this LCR from 1 January
2015. With effect from 1 January 2015, the LCR will be 60% and rising in equal
steps of 10% every year to reach the minimum of 100% LCR on 1 January 2019 as
given below:
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Effective
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1Jan.2015
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1Jan.2016
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1Jan.2017
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1Jan.2018
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1Jan.2019
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Minimum LCR
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60%
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70%
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80%
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90%
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100%
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Effective 1 January 1, 2019, the LCR should be minimum 100% (that
is, the stock of HQLA should at least equal total net cash outflows) on an
ongoing basis. However, during periods of financial stress, banks may use their
high-quality liquid assets to tackle liquidity issues and thereby falling below
100 percent.
High-Quality Liquid Assets
(HQLA):
Liquidity of an asset indicates
the ability and ease with which it can be converted to cash. Liquid assets are
those that can be converted to cash quickly in order to meet financial
obligations. Liquid assets include cash, reserves kept with central bank and
sovereign debt.
To remain viable,
banks must have enough liquid assets to meet its near-term obligations, such as
withdrawals by depositors.
Banks must hold a
stock of HQLA to cover the total net cash outflows over a 30-day period under
the prescribed stress scenario. These HQLAs must be unencumbered—that is free of any legal, regulatory or contractual
restrictions.
The HQLA should have
the fundamental characteristics of low risk; ease and certainty of valuation;
low correlation with risky assets; and listed on a developed and a recognized
exchange. And their market-related characteristics should be: active and sizeable market; low volatility;
and flight to quality.
Level
1 and Level 2 Assets:
HQLA consist of Level 1 and Level 2
assets. Level 1 assets generally include cash, reserves kept with central bank,
and certain marketable securities backed by sovereigns and central banks, among
others. These assets are typically of the highest quality and the most liquid,
and there is no limit on the extent to which a bank can hold these assets to
meet the LCR.
Level 2 assets are comprised of Level
2A and Level 2B assets. Level 2A assets include, for example, certain
government securities, corporate debt securities (including commercial paper)
and covered bonds.
Level 2B assets include lower rated
corporate bonds, residential mortgage backed securities (RMBS) and equities
that meet certain conditions. Level 2 assets may not in aggregate account for
more than 40% of a bank’s stock of HQLA. Level 2B assets may not account for
more than 15% of a bank’s total stock of HQLA.
Level 2A and Level 2B assets are
subject to haircuts ranging from 15% to 50%.
Total net cash outflows:
The term
total net cash outflows is defined as
the total expected cash outflows
minus total expected cash inflows in
the specified stress scenario for the subsequent 30 calendar days. Total
expected cash outflows are calculated
by multiplying the outstanding balances of various categories or types of
liabilities and off-balance sheet commitments by the rates at which they are
expected to run off or be drawn down.
Total
expected cash inflows are calculated
by multiplying the outstanding balances of various categories of contractual
receivables by the rates at which they are expected to flow in under the
scenario up to an aggregate cap of 75% of total expected cash outflows.
Total net
cash outflows over the next 30 calendar days =
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Total expected cash outflows – Min {total
expected cash inflows; 75% of total expected cash outflows}
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Frequency of calculation and reporting:
The LCR should be used on an ongoing basis to help monitor
and control liquidity risk. The LCR should be reported to central banks at
least monthly. However, central banks may increase the frequency to weekly or
even daily at their discretion. The time lag in reporting should be as short as
feasible and ideally should not surpass two weeks.
The LCR versus the SLR in
the Indian context:
The
Reserve Bank of India (RBI) issued the liquidity coverage ratio guidelines for
Indian banks on 9 June 2014. These are more or less in line the norms
prescribed by the Basel Committee on Banking Supervision.
Indian
banks will have to maintain this LCR over and above the statutory liquidity
ratio (SLR) prescribed by RBI. As the assets kept for LCR purpose are unencumbered, those assets will be
outside of the SLR obligation.
While
the purpose of LCR is to meet the short-term liquidity requirements, the
purpose of SLR is long-term in nature. The SLR mainly serves three purposes in India:
o It serves as a
solvency cushion for banks (ultimately, bank depositors) against any
emergencies –like liquidity crisis, bank failures, etc
o It is used by
the Central Government to raise money (government borrowings) cheaply from
banks
o RBI uses it as
a monetary policy tool to infuse (absorb) liquidity into (from) the banking
system
With
effect from 9 August 2014, the RBI cut the SLR for Indian banks by 50 basis
points to 22 percent of net demand and time liabilities (NDTL). The latest SLR
cut is expected to help Indian banks in meeting the new LCR norms.
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References:
Disclaimer: The author is an investment analyst with a vested
interest in the Indian stock markets. This is for information purposes only.
This should not be construed as investment advice. Investors should consult
their own financial advisers before taking any investment decisions. The author
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