OFR Paper Highlights Challenges in Interpreting the Liquidity Coverage Ratio

An OFR working paper released today illustrates some of the complexities in interpreting the Liquidity Coverage Ratio (LCR), a new standard set by bank regulators after the financial crisis to help ensure banks maintain enough liquid assets to cover their financial obligations during times of stress.

The Basel Committee on Banking Supervision introduced an international LCR standard in 2013, which was implemented in a final U.S. rule in 2014. The U.S. rule will be fully phased in by January 2017.

The LCR requires banks to hold enough high-quality liquid assets to survive a significant stress scenario lasting 30 days. In its most basic form, the LCR is calculated as the ratio of high-quality liquid assets to expected net cash outflows during 30 days. However, calculations of the numerator and denominator are complex and involve more than 300 inputs.

The LCR is unlike some other regulatory ratios in that a clear understanding of the mechanics of its underlying calculations is needed to interpret the LCR metric and perform informed peer analysis. Complexities in implementation and differences among jurisdictions can reduce LCR comparability among banks even for the same bank over time.

The OFR working paper uses a series of increasingly complex examples to demonstrate differences in LCRs computed under the Basel and U.S. standards. These examples demonstrate issues to consider when analyzing this new liquidity metric. For example, the paper highlights complexities in interpreting LCRs under both Basel III and the U.S. rule when banks undertake transactions that simultaneously affect the LCR numerator and denominator, and therefore, the ratio itself.

This paper is part of the OFR’s broader work monitoring and assessing the impact of changes in liquidity and capital regulations on the stability of the U.S. banking system. We pay particular attention to potential gaps in analysis, data, and policies; conflicts among policies; and financial innovations that could undermine regulatory goals and pose potential risks to financial stability.

Greg Feldberg is Acting Deputy Director for Research and Analysis at the Office of Financial Research