Rama Krishna Vadlamudi, HYDERABAD 11 August 2014

www.ramakrishnavadlamudi.blogspot.in

Liquidity Coverage Ratio or LCR

It is the share of highly liquid assets to total net cash outflows in the next 30 days

This is part of Basel III norms mandated for banks across the globe

These norms are effective 1st of January 2015 as given below:

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

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

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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 1
st
of January, 2015 (see table above).

The 2007/2008 global financial crisis forced central banks to adopt more
stringent liquidity requirementsin the form of the liquidity coverage ratio and
net stable funding ratioto manage liquidity risk in a better manner.

Let us discuss the background and more details of this liquidity coverage ratio.


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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 fundingproviding
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 banks 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.


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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
unencumberedthat 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.

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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 banks stock of HQLA. Level 2B
assets may not account for more than 15% of a banks 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.

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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.

- - -

References:

RBI Norms for Liquidity Coverage Ratio 9Jun2014

Basel III: Liquidity Coverage Ratio & other tools Jan2013

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:

http://ramakrishnavadlamudi.blogspot.in/ http://www.scribd.com/vrk100

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