The Liquidity Coverage Ratio (LCR) measures the proportion of high-quality liquid assets that financial institutions hold to ensure they can meet short-term obligations. This ratio serves as a stress test designed to anticipate market-wide shocks and safeguard financial stability. By maintaining the required LCR, institutions ensure they have sufficient capital reserves to weather short-term liquidity disruptions in the market.

Understanding LCR

A key takeaway from the Basel Accord, developed by the Basel Committee on Banking Supervision (BCBS), is the liquidity coverage ratio (LCR). The BCBS comprises 45 representatives from major financial hubs worldwide. One of its primary objectives is to ensure financial institutions maintain a minimum level of highly liquid assets to mitigate the risks associated with excessive short-term debt. This requirement helps institutions sustain fiscal solvency and promotes financial stability.

As a result, financial institutions are required to hold high-quality liquid assets (HQLA) sufficient to cover their projected cash outflows for a 30-day period. Only assets that can be quickly and easily converted to cash qualify as HQLA, ensuring liquidity during times of economic stress.

The 30-day threshold in the liquidity coverage ratio (LCR) was set based on the expectation that governments and central banks typically intervene within this period during financial crises. This standard helps institutions maintain a cash buffer to meet liquidity demands, such as bank runs, during moments of instability. By meeting this requirement, central banks like the Federal Reserve gain the necessary time to implement corrective actions, preserving the financial system's stability.

Implementation of the LCR

The LCR was first suggested in 2010, and further adjustments and approval didn't come until 2014. In 2019, the entire 100% minimum requirement will become mandatory. All financial institutions with more than $250 billion in combined assets or more than $10 billion in on-balance-sheet overseas exposure are subject to the liquidity coverage ratio. These financial institutions, sometimes known as SIFIs, are obliged to have a 100% LCR. This mandates that they keep an amount of highly liquid assets that are either equal to or higher than their net cash flow throughout a 30-day stress period. Cash, Treasury bonds, and corporate debt are some examples of assets that are very liquid.

Comparison of the LCR to Other Liquidity Ratios

A category of financial measures known as liquidity ratios is used to ascertain whether or not a business is in a position to satisfy its existing financial commitments without resorting to the solicitation of additional funding from other sources. The current ratio, the quick ratio, and the operating cash flow ratio are the three measures that are used in the computation of liquidity ratios. These ratios are used to determine a company's capacity to meet its financial obligations as well as its margin of safety. To determine whether or not short-term obligations can be covered in the coverage of an emergency, current liabilities and liquid assets are compared to one another.

The criteria that banks must meet to meet the liquidity coverage ratio is to retain a quantity of high-quality liquid assets sufficient to fund cash withdrawals for thirty days. A company's capacity to satisfy its short-term financial commitments is evaluated using liquidity ratios, which function in a manner very similar to that of the LCR.

Limitations

One of its drawbacks is that the LCR mandates that banks keep more cash on hand. This might also result in fewer loans being sent to individual borrowers and companies. One may argue that if banks make fewer loans, it could lead to slower economic development since businesses that rely on access to debt to fund their operations and expansion would not have access to cash if the amount of loans issued by banks is reduced.

On the other hand, another drawback is that we won't know until the next financial crisis whether or not the LCR offers enough of a financial cushion for banks or whether or not it is inadequate to fund cash withdrawals for thirty days. This information won't be available until the next crisis. The LCR is a stress testing to ensure that financial institutions have enough capital to weather any short-term interruptions in the flow of liquidity.