Liquidity Coverage Ratio: What is it?

Definition

The liquidity coverage ratio (LCR) is a financial metric used in the banking industry to assess a bank’s short-term liquidity risk.

What is a liquidity coverage ratio?

A liquidity coverage ratio measures the adequacy of a bank’s liquid assets to cover its potential net cash outflows over a 30-day period under stressed conditions.

The liquidity coverage ratio is calculated as follows:

Liquidity coverage ratio = (high−quality liquid assets / net cash outflows) x 100

The LCR serves as a safeguard to ensure that a bank has sufficient liquid assets to cover its short-term cash outflows in case of a severe financial or economic stress event. This reduces the risk of a bank facing a liquidity crisis.

As per standards, banks are required to maintain a minimum LCR of 100%, meaning that they should hold enough high-quality liquid assets to cover their net cash outflows over a 30-day stress period.

Example of liquidity coverage ratio

Let’s say Bank XYZ has the following:

High-quality liquid assets worth ₦100 million
Net cash outflows over the next 30 days amounting to ₦80 million

Using these numbers, we can calculate the liquidity coverage ratio:

$mi ll i o n = 1.25$

In this example, Bank XYZ has an LCR of 1.25, indicating that it holds 125% of its net cash outflows in high-quality liquid assets, which meets the regulatory requirement. This means the bank has sufficient liquidity to cover its short-term obligations over the next 30 days, providing a buffer against potential liquidity stress.