9.3 Liquidity Coverage Ratio and Net Stable Funding Ratio
3 min read•august 7, 2024
introduced two key liquidity standards: the and . These measures aim to strengthen banks' ability to withstand financial stress and promote stability in the banking system.
The LCR ensures banks have enough liquid assets to survive short-term stress, while the NSFR focuses on long-term funding stability. Both ratios require banks to maintain at least 100% coverage, balancing assets and funding sources to enhance overall liquidity.
Liquidity Coverage Ratio (LCR)
Ensuring Short-Term Liquidity
Top images from around the web for Ensuring Short-Term Liquidity
Liquidity Creation and Competition in the Banking Industry Pre and Post Arab Spring in MENA Region View original
Is this image relevant?
Analyzing Forecasts | Boundless Finance View original
Is this image relevant?
U.S. Financial Institutions | OpenStax Intro to Business View original
Is this image relevant?
Liquidity Creation and Competition in the Banking Industry Pre and Post Arab Spring in MENA Region View original
Is this image relevant?
Analyzing Forecasts | Boundless Finance View original
Is this image relevant?
1 of 3
Top images from around the web for Ensuring Short-Term Liquidity
Liquidity Creation and Competition in the Banking Industry Pre and Post Arab Spring in MENA Region View original
Is this image relevant?
Analyzing Forecasts | Boundless Finance View original
Is this image relevant?
U.S. Financial Institutions | OpenStax Intro to Business View original
Is this image relevant?
Liquidity Creation and Competition in the Banking Industry Pre and Post Arab Spring in MENA Region View original
Is this image relevant?
Analyzing Forecasts | Boundless Finance View original
Is this image relevant?
1 of 3
- Liquidity Coverage Ratio (LCR) requires banks to maintain sufficient (HQLA) to cover over a 30-day stress period
- Aims to ensure banks have adequate liquidity to withstand short-term liquidity disruptions (2008 financial crisis)
- Banks must maintain an LCR of at least 100%, meaning HQLA should be equal to or greater than expected net cash outflows over the next 30 days
- Formula:
High-Quality Liquid Assets (HQLA)
- High-quality liquid assets (HQLA) are assets that can be easily and quickly converted into cash with little or no loss of value during a stress scenario
- HQLA includes cash, central bank reserves, and certain high-quality government securities (U.S. Treasuries)
- Other liquid assets like corporate bonds and equity securities may be included in HQLA but are subject to haircuts based on their perceived riskiness
- Banks must have a diversified portfolio of HQLA to minimize concentration risk and ensure sufficient liquidity under various stress scenarios
Calculating Net Cash Outflows
- Net cash outflows represent the expected cash outflows minus the expected cash inflows over a 30-day stress period
- Cash outflows include deposit withdrawals, maturing unsecured and secured wholesale funding, and drawdowns on committed credit and liquidity facilities
- Cash inflows include maturing loans, receivables, and other contractual inflows
- Inflows are capped at 75% of outflows to ensure banks maintain a minimum level of HQLA and do not rely too heavily on expected inflows during a stress scenario
Net Stable Funding Ratio (NSFR)
Promoting Long-Term Funding Stability
- Net Ratio (NSFR) requires banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities
- Aims to reduce funding risk over a longer time horizon by requiring banks to fund their activities with sufficiently stable sources of funding
- Banks must maintain an NSFR of at least 100%, meaning should be equal to or greater than
- Formula:
Available Stable Funding (ASF)
- Available stable funding (ASF) refers to the portion of a bank's funding sources that are expected to be reliable over a one-year time horizon
- ASF includes capital, long-term debt (maturity > 1 year), and stable deposits (retail and small business deposits)
- Different funding sources are assigned ASF factors based on their perceived stability, ranging from 100% for capital and long-term debt to 50% for less stable funding sources
- Banks must maintain a sufficient level of ASF to fund their assets and off-balance sheet exposures over the long term
Required Stable Funding (RSF)
- Required stable funding (RSF) represents the amount of stable funding a bank needs based on the liquidity characteristics and residual maturities of its assets and off-balance sheet exposures
- Assets are assigned RSF factors based on their , ranging from 0% for highly liquid assets (cash, central bank reserves) to 100% for illiquid assets (long-term loans, non-performing assets)
- Off-balance sheet exposures, such as committed credit and liquidity facilities, are also assigned RSF factors based on their likelihood of being drawn down during a stress scenario
- Banks must maintain sufficient ASF to cover their RSF, ensuring they have a stable funding profile to support their assets and off-balance sheet activities over the long term
Key Terms to Review (21)
Available Stable Funding (ASF): Available Stable Funding (ASF) is a regulatory metric used to measure the stability of a financial institution's funding sources over a one-year horizon. It emphasizes the importance of maintaining a balanced funding profile by encouraging institutions to secure funding that is reliable and resilient during times of economic stress. This concept is vital for ensuring that banks have sufficient stable funding to support their long-term assets, thereby promoting overall liquidity and financial stability.
Basel III: Basel III is an international regulatory framework established to strengthen the regulation, supervision, and risk management of banks. It builds upon previous agreements and introduces more stringent capital requirements, liquidity standards, and measures to enhance financial stability, ensuring that banks can better withstand economic stress and reduce the likelihood of financial crises.
Cash flow projections: Cash flow projections are estimates of the cash inflows and outflows over a specific period, helping businesses anticipate their liquidity needs and financial health. These projections allow organizations to assess their ability to meet obligations, plan for future expenses, and make informed financial decisions. By analyzing expected cash flows, firms can determine the feasibility of investments and manage risks effectively.
Commercial paper: Commercial paper is a short-term unsecured promissory note issued by corporations to raise funds for working capital needs and other short-term financial obligations. Typically, these notes have maturities ranging from a few days to up to 270 days and are sold at a discount to face value. The quick liquidity and lower borrowing costs make commercial paper an attractive financing option for companies, which connects it closely to liquidity management and funding stability.
Credit crunch: A credit crunch is a financial situation in which there is a sudden reduction in the general availability of loans or credit, making it difficult for businesses and consumers to obtain financing. This typically occurs during times of economic uncertainty, where lenders become more risk-averse and tighten their lending standards. The implications of a credit crunch are significant, as it can lead to reduced spending and investment, ultimately impacting overall economic growth.
Current Ratio: The current ratio is a financial metric that measures a company's ability to pay its short-term liabilities with its short-term assets. It is calculated by dividing current assets by current liabilities, and it reflects the liquidity position of a business. A higher current ratio indicates better financial health and liquidity, enabling companies to meet their obligations as they come due.
Dodd-Frank Act: The Dodd-Frank Act is a comprehensive piece of financial reform legislation enacted in 2010 to promote financial stability and protect consumers in the aftermath of the 2008 financial crisis. This act established new regulatory frameworks for the financial services industry, impacting various aspects such as risk management, capital requirements, and transparency in financial transactions.
Funding Mismatch: Funding mismatch refers to the situation where a financial institution's funding sources do not align with the maturity profiles of its assets and liabilities. This disconnect can lead to liquidity risks, especially when short-term liabilities are funded by long-term assets, exposing the institution to the risk of not being able to meet its obligations as they come due.
High-quality liquid assets: High-quality liquid assets (HQLA) are assets that can be quickly and easily converted into cash without significant loss in value. They play a crucial role in ensuring that financial institutions can meet their short-term obligations and maintain liquidity during periods of financial stress, thereby enhancing stability within the financial system.
Liquidity buffer: A liquidity buffer is a reserve of liquid assets that financial institutions maintain to ensure they can meet their short-term obligations and withstand periods of financial stress. This buffer acts as a safety net, providing immediate access to cash or cash-equivalents, which is crucial for managing unexpected withdrawals or losses. It plays a critical role in maintaining stability in the financial system and is often assessed through metrics like the Liquidity Coverage Ratio and the Net Stable Funding Ratio.
Liquidity Coverage Ratio (LCR): The Liquidity Coverage Ratio (LCR) is a regulatory standard that requires financial institutions to hold a sufficient amount of high-quality liquid assets (HQLA) to cover total net cash outflows over a 30-day stress period. This measure ensures that firms can withstand short-term liquidity disruptions and enhances the overall stability of the financial system by promoting prudent liquidity risk management.
Liquidity gap: A liquidity gap refers to the difference between the amount of liquid assets available to a financial institution and the amount of cash that is required to meet its obligations. This gap highlights the potential risk a financial institution faces when it cannot convert its assets into cash quickly enough to cover liabilities. Understanding liquidity gaps is crucial for managing liquidity risk, which directly connects to maintaining adequate funding and compliance with specific liquidity requirements.
Liquidity risk: Liquidity risk refers to the potential difficulty a financial institution faces in meeting its short-term financial obligations due to the inability to convert assets into cash without incurring significant losses. This risk is critical for maintaining adequate capital levels, ensuring client asset protection, and complying with regulatory reporting requirements.
Market volatility: Market volatility refers to the degree of variation in the price of a financial asset over time, often measured by standard deviation or variance. It signifies the amount of uncertainty or risk involved in the size of changes in a security's value, which can be influenced by various factors such as economic indicators, geopolitical events, and investor sentiment. Understanding market volatility is crucial for managing liquidity and funding strategies, implementing effective hedging techniques, and estimating potential credit losses in financial reporting.
Net cash outflows: Net cash outflows refer to the total amount of cash that leaves an organization during a specific period, minus the cash that comes in. This concept is crucial for assessing a company's liquidity position and ability to meet its financial obligations, especially during periods of financial stress. It is a key component in understanding both the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), which evaluate how well financial institutions can handle cash flow needs over different time horizons.
Net Stable Funding Ratio (NSFR): The Net Stable Funding Ratio (NSFR) is a liquidity standard that requires financial institutions to maintain a stable funding profile in relation to their assets and off-balance-sheet activities over a one-year horizon. This ratio aims to ensure that banks have sufficient funding to support their activities during periods of economic stress, promoting resilience in the financial system. The NSFR complements other regulatory requirements by focusing on the stability of a bank's funding sources, which is crucial for managing liquidity risks effectively.
Quick Ratio: The quick ratio, also known as the acid-test ratio, is a financial metric that measures a company's ability to meet its short-term obligations with its most liquid assets. It is calculated by dividing current assets minus inventories by current liabilities, providing insight into a firm's liquidity position. This ratio is critical for assessing whether a company can quickly cover its liabilities without relying on the sale of inventory, which may not always be easily convertible to cash.
Repos: Repos, or repurchase agreements, are short-term borrowing transactions where one party sells an asset to another with the agreement to repurchase it at a later date for a higher price. They are crucial in the financial system as they provide liquidity and facilitate the management of cash and collateral among financial institutions, impacting liquidity coverage and funding stability.
Required Stable Funding (RSF): Required Stable Funding (RSF) refers to the minimum amount of stable funding that a financial institution must maintain to support its illiquid assets over a specified time horizon. This concept is critical for ensuring that institutions have sufficient long-term funding to withstand periods of financial stress, which directly ties into measures aimed at enhancing overall financial stability. By evaluating RSF, institutions can manage their liquidity risk and align their funding strategies with regulatory requirements.
Stable Funding: Stable funding refers to the sources of financing that a financial institution can rely on over a longer period, ensuring that it can meet its obligations without relying on short-term funding that may be volatile or withdrawn during times of financial stress. This concept is crucial for maintaining liquidity and reducing the risk of insolvency, particularly in the context of regulatory frameworks that promote financial stability.
Stress test scenarios: Stress test scenarios are hypothetical situations used to assess the resilience of financial institutions under adverse conditions. These scenarios help organizations evaluate how well they can manage liquidity and funding challenges, ensuring they have enough capital and stable funding to survive unexpected economic shocks. By analyzing these stress tests, banks can identify vulnerabilities and improve their risk management strategies.