The liquidity coverage ratio (LCR) refers to highly liquid assets held by financial institutions to meet short-term obligations. LCR forms on traditional liquidity “coverage ratio” methodologies used internally by banks to assess exposure to contingent liquidity events. The LCR guidelines ensure reduction in funding risk over a 30 days horizon by requiring banks to fund their activities with sufficiently stable sources of funding in order to mitigate the risk of future funding stress. The standard requires that, absent a situation of financial stress, the value of the ratio should not be lower than 100%.
[Stock of high quality liquid assets (HQLA)] ÷ [Net Cash outflows over a 30 days’ time period] ≥100%
In the other words, the stock of HQLA should at least equal or more than total net cash outflows is the standard requirement for LCR. (The HQLA include only those with a high potential to be converted easily and quickly into cash).
During a period of financial stress, however, banks may use their stock of HQLA, thereby falling below 100%, as maintaining the LCR at 100% under such circumstances could produce undue negative effects on the bank and other market participants. At a minimum, the stock of liquid assets should enable the bank to survive until day 30 against the potential onset of liquidity stress, by which time it is assumed that appropriate actions can be taken by management of the bank and resolve it in an orderly way. Thus, LCR assures that financial institutions have the necessary assets on hand to ride out any short-term liquidity disruptions.
