Liquidity Coverage Ratio (LCR)

Overview

The Liquidity Coverage Ratio (LCR) is a regulatory standard that requires banks to hold enough high-quality liquid assets (HQLA) to cover expected net cash outflows over a 30-day stressed period. Introduced after the 2008 financial crisis as part of the Basel III framework, the LCR aims to reduce short-term liquidity risk and help banks survive acute market stress without needing emergency support.

Key takeaways

• The LCR requires banks to maintain HQLA at least equal to net cash outflows over a 30-day stress scenario (LCR ≥ 100%).
• Assets are tiered by liquidity; only the most liquid assets count fully.
• The rule addresses short-term funding risk and complements capital requirements, which address longer-term solvency risk.
• Critics argue the LCR can underestimate likely outflows and other liquidity pressures in extreme crises.
• Changes to U.S. applicability thresholds in 2019 reduced the number of banks required to meet the full LCR, a decision questioned after some later bank failures.

What the LCR measures

The LCR is designed as a daily stress-test metric that focuses on a bank’s ability to meet short-term obligations without selling assets at fire-sale prices. It specifically measures whether available HQLA can cover projected net cash outflows during a 30-day period of severe market stress.

High-quality liquid assets (HQLA) tiers

Assets eligible as HQLA are ranked by liquidity and subject to haircuts and caps:
* Level 1: Counted at full value. Includes cash, central bank reserves, and certain sovereign securities.
* Level 2A: High-quality but less liquid than Level 1. Generally subject to a 15% haircut (counted at 85% of market value).
* Level 2B: Lower-quality liquid assets (e.g., certain corporate bonds, equities). Subject to larger haircuts and quantity limits; only a portion (commonly in the range of 50–75% of value, depending on the asset) can be included.

Regulators also set concentration limits so HQLA cannot be overly weighted toward less liquid categories.

How to calculate the LCR

Formula:
LCR = High quality liquid asset amount (HQLA) / Total net cash outflows over 30 days

Banks must maintain LCR ≥ 100%.

Example:
If a bank holds $85 billion in HQLA and projects $68 billion of net cash outflows over 30 days, then:
LCR = $85B / $68B = 125% → the bank meets the requirement.

Calculating HQLA and projected outflows requires:
* Classifying assets by tier and applying haircuts/caps
* Projecting realistic outflows using historical behavior and stress scenarios
* Accounting for collateral needs and changes in funding markets
* Modeling depositor behavior (retail vs. wholesale, insured vs. uninsured)

2019 U.S. tailoring of LCR requirements

U.S. regulators changed applicability thresholds in 2019, reducing the number of banks subject to full LCR requirements:
* Previously, banks with ≥ $250 billion in total assets or ≥ $10 billion in foreign exposure faced full LCR rules.
* After tailoring: only banks with ≥ $700 billion in assets or ≥ $75 billion in cross-border activity faced the full LCR; banks between $250–$700 billion faced reduced requirements; banks under $250 billion were exempt.

This tailoring was intended to lower compliance costs for midsized banks but has been questioned following later bank failures, which highlighted risks at some institutions that no longer had to meet the fuller LCR standards.

LCR vs. capital requirements

• LCR: Protects against short-term liquidity stress—ability to meet withdrawals and collateral calls over days to weeks.
• Capital requirements: Protect against longer-term losses—ability to absorb losses and remain solvent.
  Both are complementary: strong capital positions do not guarantee liquidity, and ample liquidity does not substitute for adequate capital.

Limitations and criticisms

Researchers and practitioners have raised several concerns:
* Stress assumptions may understate actual outflows in extreme events (e.g., rapid flight of uninsured deposits).
* The LCR may not fully capture collateral demands, interbank funding evaporation, or runs on short-term wholesale funding.
* Holding large amounts of low-yield liquid assets can reduce bank profitability, creating pressure to manage risks around the threshold rather than eliminate them.
* Narrow applicability (after regulatory tailoring) can leave some midsized banks more exposed.

Conclusion

The LCR is a central post-crisis tool to strengthen short-term resilience in the banking sector by ensuring banks hold readily marketable assets to cover 30 days of stress outflows. It complements capital rules but is not a complete safeguard against all forms of banking crises. Effectiveness depends on the assumptions used, the scope of institutions covered, and how regulators and banks manage liquidity under severe stress.

Sources

Selected foundational and research sources include Basel III LCR documentation from the Bank for International Settlements, U.S. regulatory final rules from the Office of the Comptroller of the Currency and the Federal Reserve, and academic analyses of liquidity risk at large banks.