Thursday, October 8, 2015

# OFR Report Highlights Complexity of the Liquidity Coverage Ratio

On October 7, 2015, the Office of Financial Research (OFR) published a paper highlighting the difficulties in interpreting the Liquidity Coverage Ratio (LCR), a new standard set by bank regulators after the financial crisis to help ensure banks maintain sufficient liquid assets during times of market stress. The OFR’s analysis of the LCR is part of its ongoing work monitoring the effects of changes in U.S. bank capital and liquidity regulations.

The LCR was introduced as part of the Basel Committee’s international standards in 2013, was adopted by U.S. regulators in 2014, and will be fully effective in the U.S. in January 2017. The LCR requires banks to maintain sufficient levels of high-quality liquid assets to survive a period of significant stress lasting at least 30 days. Simply put, the LCR is the ratio of high-quality liquid assets to expected net cash outflows during 30 days. According to the OFR report, however, the calculations of the numerator and denominator can be very complex, can require more than 300 separate inputs, and differences exist in the calculation of the ratio under Basel, U.S., and other jurisdictions.

"[T]here is much more to the rule than this simple summary ratio. The calculation of both the numerator and denominator are complex and involve over 300 inputs. The Basel version contains two caps in the LCR numerator to ensure asset diversification in banks’ HQLA buffers and another cap in the denominator to prevent over-reliance on cash inflows. These caps make use of min/max functions that introduce nonlinearities into banks’ LCRs and increase the complexity of forecasting and maintaining compliance, particularly during liquidity shocks. The U.S. rule contains additional min/max functions in both the numerator and denominator."

This lack of a clear understanding of the mechanics of the underlying calculations needed to interpret the LCR metric is seen by OFR as a threat to informed peer analysis. In addition, these complexities in implementation and differences in interpretations among jurisdictions can reduce LCR comparability among banks even for the same bank over time.

The OFR paper uses a series of example calculations to illustrate the differences between LCR calculations under the Basel and U.S. methods. These calculation examples, OFR posits, serve to highlight myriad issues to consider when analyzing this new liquidity metric. According to OFR, the differences between the Basel and U.S. methods also highlight some of the weaknesses of the ratio’s approach.

"Under both Basel and U.S. standards, covered banks’ LCRs can vary in complex, nonlinear ways not necessarily related to underlying liquidity risk. This is, in part, due to the use of min/max functions in the numerator and denominator. However, it is also because the metric was built using a ratio approach, creating the potential for secured lending and borrowing transactions to simultaneously affect the LCR numerator and denominator."

OFR therefore suggests that "A complementary gap approach could be used to enhance the regulatory goal of a quantifiable measure of liquidity risk with meaningful variance.” Alternatively, OFR suggests that, "although the LCR is a stress metric, liquidity stress testing could be used to address some of the shortcomings we identify in this paper."