In October 2013, the U.S. banking agencies proposed a Liquidity Coverage Ratio (“LCR”) in the United States that is more stringent than the LCR agreed to internationally by the Basel Committee on Banking Supervision earlier in 2013. 

The Role of Liquidity

The LCR is a key component of the post-crisis U.S. liquidity framework and an important step in strengthening the resiliency of banks and the stability of the financial system.  The Federal Reserve offers the following explanation of liquidity:

Liquidity is a measure of the ability and ease with which assets can be converted to cash. Liquid assets are those that can be converted to cash quickly if needed to meet financial obligations; examples of liquid assets generally include cash, central bank reserves, and government debt.  To remain viable, a financial institution must have enough liquid assets to meet its near-term obligations, such as withdrawals by depositors.

In short, liquidity allows banks to meet their obligations as they come due without needing to sell assets in an unstable market. 

The Proposed U.S. LCR

The LCR requires a bank to hold a minimum amount of unencumbered high-quality liquid assets (“HQLA”) that can be quickly converted into cash in order to withstand a 30-day liquidity stress scenario.  The premise is that these HQLA will better allow a bank to remain liquid and withstand shocks during financial or economic stress, thus preventing its failure and reducing any contagion consequences to the broader economy.

Assets that are considered HQLA are generally low risk, have little price volatility, and enjoy an active market in which they can be converted into cash. Under the proposed U.S. LCR, HQLA is divided into several categories:

• Level 1 assets, which are highly-liquid (for example cash or U.S. Treasuries) and are not subject to any haircuts or quantitative caps;
• Level 2 assets, which regulators believe to be less liquid (for example, corporate bonds) and that are capped at 40% of a banking organization’s total HQLA.  This category is further subdivided into:  (1) Level 2A assets which are subject to 15% haircuts and (2) Level 2B assets which are subject to 50% haircuts and cannot count for more than 15% of total HQLA.

The amount of liquidity that is needed in a liquidity stress scenario is effectively captured in the denominator of the LCR, Peak Net Cash Outflows, through prescribed cash inflow and outflow assumptions to a bank’s balance sheet, calculated by multiplying the outstanding balance of liabilities, off-balance sheet commitments, and contractual receivables by outflow and inflow rates included in the proposed rules.

Under the proposed U.S. LCR, Peak Net Cash Outflows would be required to be calculated for each day of the 30 calendar day stress period by subtracting the cumulative stressed cash inflows from the cumulative stressed cash outflows. Further, to ensure a minimum amount of HQLAs, the cumulative stressed cash inflows are capped at 75% of the cumulative stressed cash outflows for each day. The largest net cash outflow on any individual day of the 30 calendar day period is used for purposes of calculating the U.S. LCR (as opposed to the Basel LCR standard of cumulative net cash outflows over the 30-day stressed scenario).

Who is Covered by the Proposed U.S. LCR?

The U.S. LCR would apply to banking organizations that are mandatorily subject to the advanced approaches risk-based capital rules, their respective consolidated subsidiary depository institutions with total consolidated assets greater than $10 billion, and nonbank financial companies designated by the Financial Stability Oversight Council for supervision by the Federal Reserve that do not have substantial insurance activities.  The U.S. banking agencies’ proposal also includes a modified LCR for bank holding companies and savings and loan holding companies domiciled in the United States with at least $50 billion in total consolidated assets that are not subject to the advanced approaches risk-based capital rules and do not have substantial insurance activities.

The next issue of The Clearing House Banking Brief will provide a more detailed discussion of the proposed U.S. LCR.  For additional information, please contact Jill Hershey (jill.hershey@theclearinghouse.org, 202-649-4601) or John Van Etten (john.vanetten@theclearinghouse.org, 202-649-4617).