We have prepared this LCR calculator for you to calculate the liquidity coverage ratio. The LCR is a ratio of highly liquid assets of a bank to its expected cash outflows in a stress scenario. This ratio can tell you how likely a bank can withstand a market recession.
The following article will help you understand what LCR is and how to calculate it using the liquidity coverage ratio formula. We will also use some practical examples to better help you to understand the concept.
What is the liquidity coverage ratio? – LCR meaning in finance
The LCR is one of the ratios mentioned in the Basel III regulatory accord that is used to measure and mitigate the systematic risks that exist within the banking sector. It measures the ability of a bank to withstand short-term liquidity problems due to market disruptions using the Basel III liquidity coverage ratio formula.
More specifically, calculating the LCR allows you to understand how much liquid asset the bank needs to withstand a 30-days cash outflow under extreme scenarios. Using this ratio, the Basel Committee forces the banks to avoid excess lending in hopes of getting risky returns or profits.
Now that you know what LCR is, let's see how to use the LCR ratio formula in practice.
How to calculate liquidity coverage ratio using the LCR calculator?
Without further ado, let's look at the LCR calculation. Let's take Bank Alpha, with the following information, as an example:
- Location: Based in the US
- Cash and cash equivalents:
- Marketable securities:
- Expected 30-days cash outflows in a stress scenario:
To calculate the LCR from Basel III liquidity coverage ratio formula, you need to carry out three steps:
Calculate the highly liquid assets.
Highly liquid assetsare defined as assets that can be converted into cash in a short amount of time. Usually, they consist of the
cash and cash equivalentsand
marketable securities. Hence, we can calculate
highly liquid assetsusing the following formula:
highly liquid assets = cash and cash equivalents + marketable securities
In our example,
highly liquid assetsof Bank Alpha is:
$1,000,000 + $750,000 = $1,750,000.
Determine the expected 30-days cash outflows.
The next step is to determine the
expected 30-days cash outflows. The
expected 30-days cash outflowsis defined as the cash flowing out of the institution given a stress scenario, such as an economic crisis. In this example, Bank Alpha's
expected 30-days cash outflowsis
$1,500,000. Our economic profit calculator have detailed explanation on this concept.
Calculate the LCR.
The last step is to calculate the
LCR. We can achieve this by using the LCR ratio formula below:
LCR = highly liquid asset / expected 30-days cash outflows
Hence, Bank Alpha's
LCRis equal to:
$1,750,000 / $1,500,000 = 116.67%.
You can immediately obtain the same result with our LCR calculator, so be sure to give it a try!
How to interpret LCR?
After understanding what LCR is and how to calculate the liquidity coverage ratio, let's look at the meaning of LCR and how to interpret it.
When the Dodd-Frank Act was enacted, it stated that every bank needs to go through a series of stress tests twice per year. Part of the stress test is to analyze the bank's short-term liquidity risks, and LCR is a critical metric in the process.
According to the Basel Accord, every bank needs to have at least a 100% LCR to pass its stress test. This signifies that the banks have enough highly liquid assets to handle a liquidity stress scenario in a 30-day period.
What is a good LCR?
Every bank is required to have an LCR higher than 100%, according to the Basel III Accord. However, a higher LCR is usually better since it indicates a better ability of the bank to meet its short-term liquidity needs.
Can the LCR be negative?
Mathematically speaking, LCR can indeed be negative. However, it will mean that the banks only have highly liquid liabilities instead of highly liquid assets. This will put the bank in a very perilous position.
What is the difference between LCR and NSFR?
LCR and NSFR measure two different risks. LCR is used to assess a bank's short-term liquidity needs, and NSFR is used for assessing its long-term funding stability. The first abbreviation stands for the liquidity coverage ratio, while the second one for the net stable funding ratio.
Can LCR be applied to another industry?
Yes, technically speaking, LCR can be applied to all industries. However, it is most relevant to banks and insurance companies. This is because these companies are the custodians of other people's money and are most sensitive to market and economic conditions.