What is Liquidity Coverage Ratio?
The LCR focuses on the bank’s ability to weather a 30-day period of reduced/disrupted liquidity. The severe stress considered could be a three-notch downgrade (e.g., AA to A), a loss of deposits etc. The point is that banks and authorities should be able to sell liquid assets to meet liquidity demands during the month of disrupted liquidity, while simultaneously attempting to restore confidence in itself.
Example of Liquidity Coverage Ratio:
The LCR ratio is computed as:
high-quality liquid assets / net cash outflows in a 30-day period ≥ 100%
Liquid assets need to be at least as great as potential net cash outflows such that the bank can withstand one or more of the pressures described earlier. Examples of high-quality liquid assets (HQLA) include deposits at central banks and securities issued by central governments with a zero per cent risk weight under the standardized approach. These assets are HQLA without haircuts. Corporate debt and equity have a 50% haircut. For example, a bank with \$100 million of corporate debt could count \$50 million in its HQLA calculation. Individual mortgage loans are excluded entirely.
Why is the liquidity coverage ratio important?
The liquidity coverage ratio is the requirement whereby banks must hold an amount of high-quality liquid assets that’s enough to fund cash outflows for 30 days. Liquidity ratios are similar to the LCR in that they measure a company’s ability to meet its short-term financial obligations.