ByMichelle Clark Neely
In the wake of the financial crisis, international banking regulators have sought tools to better evaluate and manage risks in the banking sector. One of those tools—the liquidity coverage ratio (LCR)—was designed to ensure that systemically important financial institutions (SIFIs) have a 30-day supply of high-quality assets that can be quickly converted into cash in the event of a liquidity crunch.
In October, the Board of Governors put out for comment a joint proposal to implement the LCR. (Comments closed Jan. 31.) To be compliant with the rule, banks will need to hold enough high-quality liquid assets (HQLA) to cover the difference between their projected cash outflows and inflows during a specified number of days. The size of the LCR varies by bank size and institution type. The LCR is calculated by dividing an institution’s HQLA by its projected net cash outflows.
The largest domestic banks and nonbank SIFIs—those with total assets of more than $250 billion—are called covered companies, and they need enough HQLA on hand to survive a 30-day stress period. The stress period for institutions with assets of $50 billion to $250 billion—the so-called “modified” LCR companies—is 21 days. Under the Board’s proposal, banks with assets of less than $50 billion are exempt from the rule, as are depository institution holding companies, designated companies with substantial insurance operations, and savings and loan holding companies with substantial commercial operations.
Assets that can be designated HQLA must be liquid and readily marketable, a reliable source of funding in repo or sales markets and not an obligation of a financial company. The Board has divided HQLA—the numerator of the LCR—into three categories, and limits are placed on how much each asset type and category can contribute to the total.
|HQLA Category||Permitted Assets||Haircut and Limits|
||No haircut, no limits|
||15 percent haircut, up to 40 percent of HQLA when combined with Level 2B assets|
||50 percent haircut, up to 15 percent of HQLA|
For the denominator—the difference between an institution’s total stressed cash outflow and inflow amounts, or net cash outflows—the technical definition is designed to distinguish between stable funding sources, like core deposits, and more volatile ones, like brokered deposits. Liabilities are assigned to one of five outflow categories: secured retail funding, unsecured wholesale funding, secured short-term funding, commitments and Federal Reserve Bank borrowings. Outflow rates are assigned to each category to capture the likelihood that these liabilities won’t stick. For secured retail funding, for example, stable retail deposits that are fully insured by the Federal Deposit Insurance Corp. are assigned an outflow rate of 3 percent, while uninsured retail-brokered sweep deposits are assigned a 40 percent outflow rate. At the extreme end, commercial paper and short-term secured funding not backed by HQLA receive outflow rates of 100 percent.
An institution with an LCR of 100 percent or more complies with the rule, with a few caveats. First, cash inflows are capped at 75 percent of cash outflows to ensure that a portion of an institution’s liquidity needs are met by HQLA. Second, an institution’s primary federal banking regulator can require it to hold more HQLA than the U.S. minimum or take other actions to boost liquidity if deemed insufficient.
The U.S. LCR proposal is consistent with the Basel standard in most respects but is more restrictive in some areas. Under Basel III, bankers have until Jan. 1, 2019, to be in full compliance with the liquidity standards. Covered and modified LCR U.S. companies will be subject to a more accelerated schedule—beginning in 2015—and will need to be fully compliant by Jan. 1, 2017. Another difference between the Basel III standard and the U.S. LCR proposal is that covered U.S. companies need to hold HQLA against the largest net cumulative cash outflow during a 30-day period, rather than the outflow at the end of a 30-day period. Modified LCR companies use a 21-day period and measure net cumulative outflow at the end of that 21-day period.
In addition to concerns about the toughness of the U.S. proposal compared with its Basel III counterpart, commenters have noted problems reconciling the LCR with other regulatory changes. Officials from the nation’s largest banks have complained that a proposal to implement a supplementary leverage ratio conflicts with the goal of having institutions hold more liquid assets. They argue that a higher leverage ratio would put pressure on banks to hold only the barest minimum of liquid assets on their books and to forgo activities that create liquid assets on balance sheets. Analysts have also wondered what will happen to the prices of very liquid assets when the Federal Reserve begins to unwind its balance sheet and competition heightens for what could be a dwindling supply of HQLA.