Liquidity Coverage Ratio (LCR) The Liquidity Coverage Ratio (LCR) is a regulatory standard introduced under the Basel III framework to strengthen the resilience of banks against short-term liquidity shocks. Its primary objective is to ensure that financial institutions maintain an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be easily converted into cash to meet their liquidity needs over a 30-day stress scenario. By mandating this buffer, the LCR aims to "buy time" for bank management and supervisors to address liquidity crises or resolve the institution in an orderly manner.
According to the Bank for International Settlements (BIS) and regulatory literature, key aspects of this framework include:
The Calculation: The ratio requires the value of a bank’s HQLA to be at least 100% of its total net cash outflows over the next 30 calendar days. These outflows are calculated based on a standardized stress scenario that assumes idiosyncratic and market-wide shocks, such as deposit run-offs and the loss of unsecured wholesale funding.
Asset Composition: Banks typically comply with the requirement by increasing their holdings of liquid assets, particularly central bank reserves and government bonds, rather than by shrinking their overall balance sheets.
Economic Trade-offs: While the LCR effectively reduces reliance on fragile short-term funding and internalizes fire-sale externalities, it can crowd out productive lending to the real economy as banks replace loans with liquid assets.
Interaction with Capital: The LCR is designed to complement capital regulation; while capital requirements address solvency and insolvency risk, the LCR specifically targets rollover risk and short-term liquidity resilience.
