Why the liquidity coverage ratio impacts financial markets

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What is the liquidity coverage ratio (or LCR)?

The LCR defines the amount of highly-saleable short-term securities and central bank reserves that must be held by financial institutions (XLF) (KRE). It’s the ratio of the High-Quality Liquid Assets (or HQLA) divided by the projected net cash outflows over a specified period. HQLAs help the institution meet its short-term funding requirements. These assets can be denominated in high-quality corporate debt (BND), U.S. Treasuries (TLT), or publicly-traded equities (SPY). A higher ratio implies a higher margin of safety and vice versa.

Part 6

U.S. Fed Governor Daniel Tarullo testifies to the Senate Committee on implementing the Dodd-Frank Act 

The new LCR standard for U.S. banks is based on the Basel Accord. However, it has several provisions that are stricter than the Basel Committee on Banking Supervision’s (or BCBS) requirements. There are differences in certain key areas. Major differences include:

  • Differences in the quality of assets that qualify for inclusion under the LCR for U.S. banks
  • The requirement for the LCR for U.S. banks assumes a higher rate of outflows for specific types of funding
  • A faster implementation pace is required for U.S. banks
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“The accelerated phase-in of the U.S. LCR reflects our objective that large U.S. banking firms maintain the improved liquidity positions they have already built following the financial crisis, in part because of our supervisory oversight. We believe the LCR will help ensure that these improved liquidity positions will not weaken as memories of the financial crisis fade,” said Governor Tarullo.

Financial market implications

A more stringent LCR requirement would mean that U.S. financial institutions would either maintain higher reserves at the Fed or increase their holdings of high-quality, highly-liquid, eligible stocks and bonds. This would increase the demand for these assets. This could lead to more Treasury bills (or T-bills) and Floating Rate Notes (or FRNs) being issued at future Treasury auctions.

However, issuance could be subject to a cap. The cap is based on the Federal government’s debt ceiling. If the issuance amount isn’t increased, this could provide headwinds for higher yields at Treasury auctions. It could also cause higher demand for alternative eligible assets.

Supplementary leverage ratio and enhanced supplementary leverage ratio

In his testimony, Governor Tarullo spoke about the enhanced leverage requirements for U.S. banks. He discussed requirements over and above those specified by the Basel Committee on Banking Supervision (or BCBS). We’ll discuss this in the next part of the series.

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