Monday 11 August 2014

What is Liquidity Coverage Ratio?-VRK100-11Aug2014





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

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:







Effective
1Jan.2015
1Jan.2016
1Jan.2017
1Jan.2018
1Jan.2019






Minimum LCR
60%
70%
80%
90%
100%

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 =

 Total expected cash outflows – Min {total expected cash inflows; 75% of total expected cash outflows}

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 blogs at:


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