The Difficult Business of Measuring Banks’ Liquidity: Understanding the Liquidity Coverage Ratio

32 Pages Posted: 28 Oct 2015

See all articles by Jill Cetina

Jill Cetina

Government of the United States of America - Office of Financial Research

Katherine Gleason

Government of the United States of America - Office of Financial Research

Date Written: October 7, 2015

Abstract

In the wake of the financial crisis of 2007-09, the Basel Committee on Banking Supervision recommended bank regulators adopt a new short-term liquidity requirement, the liquidity coverage ratio (LCR), to promote greater liquidity resilience. U.S. bank regulators announced the final rule implementing that recommendation in 2014. We highlight 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. Furthermore, we show how the numerator and denominator caps in the LCR formulas introduce nonlinearities that add to the complexity of interpreting changes in the metric. LCRs calculated under the U.S. rule are more volatile and difficult to interpret than LCRs calculated under the Basel standard. This is because the U.S. rule adds a time dimension to the LCR’s volatility through inclusion of a maturity mismatch add-on term in the denominator to account for the peak-day net cash outflow during the 30-day window. Unlike some other regulatory ratios, bank supervisors, analysts, and investors need to have a clear understanding of the mechanics of LCR calculations to interpret the LCR metric, separate signal from noise, and perform informed peer analysis. In this paper, we demonstrate how the LCR is calculated under both Basel and U.S. rules to help market participants, the public, and researchers better understand this new liquidity metric.

Keywords: Banking, funding

JEL Classification: G14, G18, G21, G28

Suggested Citation

Cetina, Jill and Gleason, Katherine, The Difficult Business of Measuring Banks’ Liquidity: Understanding the Liquidity Coverage Ratio (October 7, 2015). Office of Financial Research Working Paper No. 15-20, Available at SSRN: https://ssrn.com/abstract=2681372 or http://dx.doi.org/10.2139/ssrn.2681372

Jill Cetina (Contact Author)

Government of the United States of America - Office of Financial Research ( email )

717 14th Street, NW
Washington DC, DC 20005
United States

Katherine Gleason

Government of the United States of America - Office of Financial Research ( email )

717 14th Street, NW
Washington DC, DC 20005
United States

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