How is the Liquidity Coverage Ratio (LCR) calculated and what qualifies as High-Quality Liquid Assets?
I'm studying liquidity risk for FRM II and the LCR formula looks simple — HQLA divided by net cash outflows — but the details of what counts as HQLA and how to calculate outflows are complex. Can someone walk through the components?
The Liquidity Coverage Ratio (LCR) was introduced under Basel III to ensure banks hold enough liquid assets to survive a 30-day liquidity stress scenario. The intuition is simple: if there's a run on the bank lasting 30 days, can it meet its obligations without selling illiquid assets at fire-sale prices?
The Formula:
LCR = Stock of HQLA / Total Net Cash Outflows over 30 days ≥ 100%
High-Quality Liquid Assets (HQLA):
HQLA are assets that can be easily and immediately converted to cash with little or no loss of value, even during times of stress.
Level 1 Assets (No Haircut — Count at 100%):
- Cash
- Central bank reserves (excess reserves)
- Government securities with 0% risk weight (US Treasuries, German Bunds, JGBs)
- Certain multilateral development bank securities
Level 2A Assets (15% Haircut — Count at 85%):
- Government securities with 20% risk weight
- Corporate bonds rated AA- or better
- Covered bonds rated AA- or better
Level 2B Assets (25-50% Haircut — Limited to 15% of Total HQLA):
- Corporate bonds rated A+ to BBB- (50% haircut)
- Certain equities in major stock indices (50% haircut)
- Residential mortgage-backed securities rated AA or better (25% haircut)
Cap: Level 2 assets combined cannot exceed 40% of total HQLA. Level 2B cannot exceed 15% of total HQLA.
Total Net Cash Outflows:
Outflows are calculated by multiplying each liability category by its assumed run-off rate under stress:
| Liability | Run-Off Rate |
|---|---|
| Stable retail deposits (insured) | 5% |
| Less stable retail deposits | 10% |
| Unsecured wholesale (operational) | 25% |
| Unsecured wholesale (non-operational) | 40-100% |
| Secured funding (government collateral) | 0% |
| Secured funding (other collateral) | 15-100% |
Inflows (amounts the bank expects to receive) are also calculated, but capped at 75% of total outflows — the bank cannot assume it will receive enough inflows to avoid needing any HQLA.
Numerical Example:
Pacific Coast Bank holds:
- $80B in Level 1 HQLA
- $30B in Level 2A HQLA (after 15% haircut = $25.5B)
- Total HQLA = $105.5B (Level 2 share = 24.2%, within 40% cap)
Total outflows = $120B. Total inflows = $30B (capped at 75% × $120B = $90B, so $30B is within cap).
Net outflows = $120B - $30B = $90B
LCR = $105.5B / $90B = 117.2% (above the 100% minimum)
Exam Tip: Know the HQLA levels, haircuts, and caps, plus the key run-off rates for retail vs wholesale deposits.
Practice LCR calculations in our FRM Part II question bank.
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