Could a bank survive 30 days without access to new funding? The Liquidity Coverage Ratio (LCR) aims to answer precisely that question. This key metric not only measures resilience to short-term liquidity shocks but has also become one of the cornerstones of modern banking regulation. But do you know how to calculate it and what it really means?
Since its introduction over a decade ago, the Basel III framework has placed the LCR at the heart of efforts to strengthen the financial system. Alongside the Net Stable Funding Ratio (NSFR), it forms part of a dual standard designed to safeguard liquidity under stress. In this article, we’ll focus on understanding the LCR in depth. We'll cover the NSFR in a future article.
The Liquidity Coverage Ratio (LCR) is one of the key pillars of prudential regulation under the Basel III framework. It aims to protect the banking system from short-term liquidity shocks.
So, how does it work?
The LCR sets a minimum ratio that strengthens a bank’s short-term liquidity risk profile. It ensures that a bank maintains a sufficient stock of High-Quality Liquid Assets (HQLA) to cover net cash outflows during a significant stress scenario over 30 days.
The HQLA buffer should enable the institution to survive for at least 30 days during a liquidity stress event. By this time, remedial measures from the bank or its supervisor are expected to be in place.
International standards require banks to maintain an LCR at or above 100% under normal conditions. This means that available liquid assets must fully cover projected net cash outflows over a month. Although initially designed for internationally active banks, the LCR has been adapted to suit various jurisdictions and risk profiles.
So, how is the LCR calculated?
The LCR formula is structurally simple but operationally demanding:
Let’s break down its components:
High-Quality Liquid Assets (HQLA) are the core buffer that banks must hold to meet liquidity demands. These assets can be quickly and easily converted into cash with little or no loss in value—even under stressed market conditions—making them the cornerstone of the LCR.
So, what makes a liquidity asset “high quality”?
Basel III uses strict criteria to ensure that these assets are genuinely liquid, even under extreme conditions. An asset qualifies as HQLA if it meets the following:
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→ Real liquidity, not theoretical: The asset must be easily convertible to cash with minimal loss, even in stressed markets. → Strong credit quality: Only low-default-risk issuers with solid credit ratings are accepted. No subordinated debt or complex structures. → Transparent valuation: The assets must be traded in active markets with publicly available and verifiable prices. If it requires a valuation model, it doesn’t qualify. → Low correlation with risky assets: They should not collapse alongside other liquid assets in times of market stress. → Proven track record: The asset must have demonstrated liquidity, even in past crisis episodes. → Presence in active markets: It should trade in markets with volume, depth, and diversified participation. → Immediate availability: It cannot be pledged as collateral or subject to legal restrictions. → Preferably central bank eligible: If the asset is accepted as collateral in central bank operations, even better. |
In short, “high quality” means these assets remain reliable sources of liquidity—whether sold or used as secured borrowing—even during market-wide or idiosyncratic crises. In such scenarios, they often benefit from a “flight to quality” effect.
Basel classifies HQLA into two levels based on the assets held on the first day of the stress period:
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Assets |
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Level 1 |
Level 2 (A and B) |
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Specifications |
The assets may include the following, among others, with the same quality:
Cash, central bank reserves, marketable securities guaranteed by member state central governments and central banks, top-level public sector entities, the International Monetary Fund, or certain multilateral development banks. |
May represent only up to 40% of total liquid assets. The following, among others: Marketable securities guaranteed by certain regional and local authorities, high-quality covered bonds, asset-backed securities, and corporate debt securities.
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Valuation |
These assets are subject to very low haircuts. They are traded in repo or cash markets, broadly. |
These assets are subject to higher haircut levels. |
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Common Characteristics |
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In summary, Basel III requires HQLA to be high-quality, low-volatility, and easily monetizable assets. In a crisis, there’s no room for experimentation—only instruments that deliver cash without compromising stability count.
Together, the LCR enhances financial stability by reducing banks’ vulnerability to stress, reinforcing market confidence, and protecting depositors and investors.
The LCR is calculated as:
Net Cash Outflows = Gross Cash Outflows – Adjusted Cash Inflows
It reflects the total expected cash outflows minus expected cash inflows over the next 30 calendar days in a stressful scenario.
Gross Outflows: Calculated by multiplying the outstanding amounts of liabilities and off-balance-sheet commitments by the expected drawdown or withdrawal rates.
Adjusted Inflows: Calculated by multiplying the amounts of receivables by the expected inflow rates—capped at 75% of total expected cash outflows.
Important: An asset cannot be counted both as part of the HQLA stock (numerator) and as a projected cash inflow (denominator).
Also note: The defined LCR stress scenario is a supervisory minimum. Banks are expected to conduct additional internal stress tests using longer time horizons and institution-specific risks.
Spoiler alert: Not quite. But here’s what you can and can’t do.
While financial statements offer a solid overview of a bank’s balance sheet, calculating the LCR from them is like solving a puzzle with missing pieces. It all comes down to the depth and granularity of what’s disclosed. You’ll get a rough picture, but not the precision required by regulation.
As shown earlier, the LCR has two main components:
Traditional liquidity statements - like cash flow statements or financial position reports - weren’t designed with Basel III in mind. The consequence is that it leads to several limitations:
Despite limitations, these reports can offer hints:
Say a bank reports:
A basic LCR estimate:
LCR = HQLA (Level 1) / Net Outflows = (200 + 300) / 400 × 100 = 125%
But caution: this figure is misleading. In practice, you would need to:
Financial statements are a good starting point, but they are far from sufficient for a regulatory LCR calculation. To get a reliable estimate, you need:
Internal bank data
Stress-adjusted figures by liability class
Official HQLA classifications by level
Supervisor-adjusted parameters for each jurisdiction
In short, financial reports tell you what the bank holds, but not how it will perform under stress. To assess true resilience, you need to look under the hood.
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