Is your LCR (Liquidity Coverage Ratio) fit for purpose?

In 2014, the Liquidity Coverage Ratio (LCR) was a much-needed response to the liquidity crises that exacerbated the global financial meltdown. The regulation requires banks to hold enough high-quality liquid assets (HQLA) to cover net cash outflows during a 30-day stress period, ensuring that banks have the means to withstand short-term liquidity shocks. As with any regulatory framework, the LCR has had its limitations. Despite having high LCRs, we have seen banks fail—some with a bang, others with a whimper.  

Ten years on, it’s worth asking: Has the LCR achieved its intended goals, and is it fit for purpose?

Rethinking the Liquidity Coverage Ratio, and the future of liquidity management

Over the years, banks have worked to meet LCR requirements, and in many ways, the regulation has succeeded in increasing overall liquidity within the banking system. Banks are now generally more cautious in their liquidity management and have strengthened their HQLA buffers.

While the LCR is an important safeguard, the failure of several banks with high LCRs raises important questions: What went wrong, and why wasn’t the LCR sufficient in these cases? Could it be that in some instances, even if the banks had maintained an even higher LCR, the outcome would have remained the same?

Martin Macko brings deep expertise in capital markets, liquidity management, and regulatory compliance. At Bearning, he advises banks on navigating regulatory changes, including the impacts of digital currencies and emerging financial technologies. Bearing also runs training programs focused on asset and liability management (ALM), treasury, financial bank management, financial markets, banking regulation, and risk management.

In this article, Macko, along with Planixs liquidity expert Nick Applebee, discuss the complexities of LCR, examine why the current approach to liquidity management may fall short, and explore how sharp-sighted firms are adapting. 

High LCR doesn’t always mean strong liquidity resilience

We have learned that a higher Liquidity Coverage Ratio doesn’t always equate to robust liquidity. The LCR is designed to address a short-term stress scenario, but it doesn’t account for every liquidity challenge a bank might face, especially in highly volatile or unpredictable environments. As Macko says,

“One issue is that the LCR can incentivise a focus on simply accumulating a large buffer of HQLA, without necessarily addressing the broader liquidity risks a bank might face.”

For example, the regulation assumes that holding a larger buffer is better, but it doesn’t always account for where that buffer is held or how quickly it can be accessed during periods of stress. In certain cases, banks that failed had HQLA locked up in assets that, while liquid on paper, were not accessible in real-time when the crisis hit.

“Credit Suisse had a robust Liquidity Coverage Ratio coverage ratio designed to handle asset withdrawals over a 30-day period. However, the problem was that the same assets meant to cover long-term needs were being used immediately—either for early payments, pre-funding accounts, or pledging collateral. This unexpected demand drained the liquidity they thought was secure, leaving them without the necessary resources when they needed them most.” —Pete McIntyre, Liquidity Expert, Planixs

The LCR is not particularly granular in capturing liquidity dynamics like intraday outflows, which can have a critical impact on a bank’s stability. Intraday liquidity management has become increasingly important as financial markets, their dynamics and technology have evolved, yet the LCR was never designed to account for these intraday liquidity demands.

Macko says that it’s worth taking a look at a key September 2023 speech from Pablo Hernández de Cos, Chair of the Basel Committee on Banking Supervision (BCBS), which provides a punchy summary of evolving BCBS thinking.

“While each of the banks that failed during the turmoil had idiosyncratic features, they all ultimately succumbed as a result of significant liquidity outflows and an inability to maintain sufficient stable funding.” —Pablo Hernández de Cos, Chair of the Basel Committee on Banking Supervision (BCBS)

This type of critical thinking is not confined to the Basel framework. The Financial Stability Board (FSB) is reviewing its approach in light of recent financial disruptions, such as the events of March Madness. The Federal Reserve has identified intraday liquidity as a priority area for inspection in 2024. The European Central Bank has been discussing the limitations of the existing LCR regime. Additionally, in Switzerland, Finma’s new Liquidity Ordinance will introduce liquidity add-ons to address LCR weaknesses and establish ring fenced intraday liquidity buffers.

What has changed since the LCR’s introduction?

Intraday liquidity risk is a prime example of how operational realities have shifted. Today’s banks must think not only about how they manage liquidity over a 30-day period but also how they respond to liquidity pressures in real time, particularly as high-speed transactions and real-time payments become more prevalent. The question of where liquidity buffers are held and how accessible they are in a crisis has become more critical. Banks must now consider whether their LCR-compliant buffers can truly be relied upon.

Additionally, we are seeing added layers of unpredictability and complexity to the environment banks operate in today.

• Technological advancements, such as real-time payment systems and blockchain technology
• New financial products, e.g., complex derivatives, cryptocurrencies, and decentralised finance (DeFi) instruments
• Shifting market dynamics, including increased market volatility, rapid capital flows, and heightened competition from fintech disruptors
• Increased interconnectivity of risks, with greater emphasis on liquidity risk due to globalised financial markets and tighter correlations between asset classes and sectors
• Social media influence, which can rapidly amplify crises by spreading panic or misinformation at unprecedented speeds

These developments have prompted regulators and banks alike to reconsider whether the LCR, in its current form, is enough to ensure liquidity resilience.

In tandem, consumers and investors may shift their behaviour in response to changes in interest rates, particularly when alternatives can offer attractive returns. This shift could impact traditional banking liquidity, further complicating the regulatory landscape.

As Macko says, “these are not small challenges” for regulators tasked with addressing the complexities introduced by fintech and digital currencies.

What are the options for the future of liquidity regulation?

Macko predicts that regulatory changes will continue. Several new ideas are emerging, such as the possibility of a non-risk-based liquidity model or a 7-day Liquidity Coverage Horizon (LCH) to better capture short-term liquidity stresses.

Non-risk-based liquidity models would aim to simplify the regulatory framework by focusing more on operational liquidity needs and less on complex, model-driven risk assessments. A 7-day LCH, meanwhile, would address the growing concern that liquidity crises often unfold over a much shorter period than the 30 days captured by the LCR. Both of these options, however, would require timely, accurate, and comprehensive liquidity data to be effective.

This brings us to a critical point: the importance of real-time data. No matter which liquidity regulation framework is used, having access to precise, real-time information is essential. Banks need to understand their liquidity positions on a minute-by-minute basis, especially as intraday liquidity becomes more critical. Without high-quality, reconciled data, any regulatory framework—whether it’s LCR, LCH, or a new model—will struggle to be truly effective.

It is important to consider how well different banks can determine the appropriate thresholds for liquidity assessments. Each institution’s capabilities can vary significantly, impacting their ability to manage liquidity effectively in real time. As a result, regulatory measures may need to be tailored to account for these differences, ensuring that all banks can comply with requirements while maintaining financial stability.

Continuous self-assessment Is key

Another crucial consideration is that liquidity regulation can never be completely prescriptive. While frameworks like the Liquidity Coverage Ratio provide important guardrails, banks must take responsibility for continually assessing their own liquidity risks and vulnerabilities. This means not just meeting regulatory requirements but thinking critically about where their specific risks lie and how they can be mitigated.

“Do I have the information necessary to understand and manage my liquidity in real time? This question ties directly to cultivating a stronger culture of risk awareness and anticipating potential pitfalls. If the regulator can’t address the issue, then it’s up to banks to take charge.” —Nick Nicholls, Liquidity Expert, Planixs

For instance, institutions should continually assess how their operations evolve—whether through new technologies, markets, products, or other changes—and understand how these developments impact their liquidity risk profiles, rather than waiting for regulation to catch up.

The role of technology and real-time analysis

In this context, technology will play an increasingly vital role. Banks that use the Realiti suite from Planixs  try to avoid having excessive cash buffers, instead they focus on really accurate cash flow forecasting, real time monitoring and control as well as advanced data analytics.

You can see how this approach transforms how banks see and use their data so they can:

– “Control payment flows. Realiti has transformed our liquidity management. We’ve reduced trapped liquidity by $300 million, which not only saves us $4 million annually but also allows us to allocate resources more effectively.”

– “Significantly reduce our buffer / add ons” 

– “Aggressively fend off the regulator”

– “Use real-time data to shift decision-making from guesswork to data-driven insights, leading to more accurate liquidity management and financial forecasting.”

– “Achieve over £500,000 reductions  in annual staffing costs” 

– “See ROI of over 400% over the first year” 

This feedback from our clients speaks volumes. FIs like SIX, National Bank of Canada and Scotia Bank have seen Realiti generate value exceeding $tens of millions per year. 

Looking ahead, it is essential to acknowledge whether we adopt a 7-day or keep 30-day LCR framework, a bank’s capabilities to manage liquidity effectively are key. Without the right tools and infrastructure, the end result may remain the same, underscoring the need for continuous improvement in operational capabilities alongside regulatory adaptations.