Definition
The liquid coverage ratio (LCR) refers to the proportion of highly liquid assets held by financial institutions, to ensure their ongoing ability to meet short-term obligations. This ratio is essentially a generic stress test that aims to anticipate market-wide shocks and make sure that financial institutions possess suitable capital preservation, to ride out any short-term liquidity disruptions, that may plague the market.
Formula
LCR fomular is calculated by dividing the bank’s high-quality liquid assets by their total net cash flows over the course of a specific, 30-day stress period.
LCR = High-Quality Liquid Asset Amount (HQLA) / Total Net Cash Flow Amount
So what is High quality liquid asset amount?
HQLAs are assets with the potential to be converted into cash quickly an easily. Under the Basel Accord, there are three categories of liquid assets – level 1, level 2A and level 2B
Level 1: these assets include coins and banknotes, central bank reserves and marketable securities. Level 1 assets aren’t discounted when you calculate the LCR ratio.
Level 2A: These assets include securities issued/guaranteed by specific sovereign entities or multilateral development banks, as well as securities issued by US government-sponsored enterprises. Level 2A assets have a 15% discount.
Level 2B: these assets include investment-grade corporate debt and publicly-traded common stock. Level 2B assets have a 25 – 50% discount.
Banks and financial institution should attempt to achieve a liquidity coverage ratio of 3% or more. In most cases, banks will maintain a higher level of capital to give themselves more of a financial cushion.
Source: Investopedia and Gocardless
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