Understanding Liquidity Coverage Ratio
The term Liquidity Coverage Ratio is a term related to banks and financial institutions. Then what is LCR or Liquidity Coverage Ratio?, is the proportion of highly liquid assets owned by banks or financial institutions, to ensure their sustainable ability to meet short-term obligations. a ratio that measures the proportion of highly liquid assets of a bank or debt institution, with the aim of knowing the ability of the bank or financial institution to meet its short-term obligations on a sustainable basis. In fact, LCR is a form of stress test for banks and financial institutions to ensure that banks have a financial structure that is able to deal with shocks in the economy that disrupt short-term liquidity. In this case the bank must be able to survive in the face of economic shocks for up to 30 days.
Calculation of Liquidity Coverage Ratio (LCR)
The formula for calculating LCR is:
LCR = High quality liquid asset amount (HQLA) / Total Net Cash Flow
In the above formula there is the term High quality liquid asset amount (HQLA, then what is HQLA?, HQLA is an asset of a bank / financial institution that can be easily converted into cash. There are three categories of liquid assets, namely:
Level 1, which includes assets in this category include coins and banknotes, and marketed securities. Assets of this category are used in full value in calculating the LCR . ratio
Level 2A, which includes assets in this category include securities issued by government-sponsored companies and securities issued or guaranteed by certain sovereign entities or multilateral development banks. When calculating the LCR ratio of assets of this category at a discount of 15%.
Level 2B, which includes assets in this category include publicly traded common stock including investment grade corporate debt. When calculating the LCR ratio of assets of this category at a discount of 25% to 50%.
Benefits of Liquidity Coverage Ratio (LCR)
From the LCR, we can determine the resilience of banks in facing short-term risks, such as sudden shocks in the economy. When faced with a shock, banks must have sufficient liquid assets to cover their liabilities and expenses within up to 30 days. Why use 30 days as a reference?, because 30 days is the time needed by the central bank and government to respond to extraordinary events in the form of financial crises. The 30-day period is also an opportunity for the central bank to take corrective and countermeasures against the financial crisis facing an economy.
Weaknesses of Liquidity Coverage Ratio (LCR)
The main weakness of LCR is that it cannot ensure that banks and financial institutions are truly resilient to financial crises, the resilience of banks and financial institutions can only be known after a financial crisis occurs. Another drawback is that banks’ need to hold on to their liquid assets to deal with short-term crises within 30 days has resulted in less funds being available to finance loans to their customers.
LCR represents the proportion of highly liquid assets held by financial institutions to ensure that they can meet their short-term obligations in the ongoing period. This ratio is essentially a general stress test aimed at preventing shocks at the market level and ensuring that financial institutions have sufficient capital retention to eliminate short-term liquidity disruptions that can hit the market.
Liquidity Coverage Ratio / asset coverage is naturally similar to debt service coverage, but what differs is the type of inspection, namely asset balance sheets rather than comparing income and debt levels. This ratio is determined using the following formula:
LCR = Total liquid assets / Total Funds Required.
The rule of thumb here is that utilities must have at least 1.5 overlapping assets and industrial firms must have at least 2.
How to Take Liquidity Coverage Ratio Data
Investors can use LCR in two ways. First, track changes in the company’s debt situation over time. Second, in some cases where debt service coverage is barely within the acceptable range, you may want to review the company’s recent history. If the ratio gradually decreases, it may only be a matter of time before it falls below the recommended value.
Coverage ratios are also valuable when a company is tested against its competitors. Valuation of similar ventures is very important because an acceptable level of interest coverage in one industry may be perceived as risky in another.
The hedging indicators I described earlier take several forms and can be used to identify companies in potentially difficult financial situations, although a low indicator doesn’t necessarily indicate that a company is in financial trouble. Because many factors affect this ratio.
The LCR was developed by the Basel Committee on Banking Supervision (BCBS), a group of representatives from the world’s financial centers. It was first proposed in 2010 before receiving final approval in 2014, although a 100% minimum is not required until 2019. Banks must maintain liquidity equivalent to at least 100% of projected cash outflows during difficult times.
In simple terms, the liquidity coverage ratio is a test during crisis or difficult times designed to test whether banks and financial institutions have sufficient capital to overcome short-term liquidity disruptions, this applies to banks with total consolidated assets of more than $250 billion or banks with foreign assets. more than $10 billion. This Liquidity Coverage Ratio (LCR) shows how much of a banking organization’s liquid assets are needed to cover the increased flow of funds during a month in the event of a crisis.
History
In 2013, Saudi Arabia became the first country to introduce LCR calculations, and since 2015 the standard has become mandatory for banks from European Union countries. And the LCR is one of the guidelines developed by the Basel Committee in response to the 2008 crisis and is also part of the Basel III agreement. Currently LCR is used by 45 countries and can be said to have been considered as a liquidity standard commonly used in the world.
Task Liquidity Coverage Ratio (LCR)
* Implementing a fundamentally new approach to liquidity risk management in banks.
* Contribute to the resilience of banks against short-term and long-term liquidity shocks.
* Build stability with significant outflow of customer funds.
* Forces banks to maintain the necessary inventory of highly liquid assets.
* Encourage banks to assess their liquidity as often as possible over a 30 day period.
