Liquidity Coverage Ratio

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Context

• The Reserve Bank of India (RBI) has issued draft guidelines to enhance the Liquidity Coverage Ratio (LCR) framework for banks.
• This move is in response to the rapid transformation in banking technology.
• With mobile and internet banking allowing instant withdrawals, the RBI is concerned about the increased risk of sudden, large-scale withdrawals, which could destabilize banks.
• Previously, withdrawals required physical visits to branches, making them less prone to rapid changes.

 RBI's Concern

• The RBI has highlighted that while technology has facilitated quick banking transactions, it also increases the risk of liquidity issues. The RBI's review aims to bolster banks' liquidity resilience to manage these new risks effectively.

 Implications for Banks

New Guidelines on Deposits
Under the new draft guidelines, banks are required to assign an additional 5% run-off factor for retail deposits with internet and mobile banking facilities. This means:

• Stable retail deposits with internet/mobile banking will have a 10% run-off factor.
• Less stable deposits with internet/mobile banking will have a 15% run-off factor.
• The intention is to ensure banks are prepared for potential rapid withdrawals due to the ease of technology.

 Treatment of Wholesale Funding

• The RBI has also stated that unsecured wholesale funding from non-financial small business customers should be treated similarly to retail deposits in terms of liquidity requirements.

 Analysts' Views

Impact on Banks

• Banking analysts anticipate that the new rules will affect banks' liquidity needs.
• The 5% increase in the run-off factor could require banks to set aside an additional 3-4% of their loans as liquidity reserves.
• This change might impact core earnings, with potential effects on Net Interest Margins (NIMs), Return on Assets (RoA), and Profit After Tax (PAT).

 Projected Effects

• Core Earnings: Analysts predict a 7-10 basis points reduction in NIMs, a 6-9 basis points decrease in RoA, and a 3-7% drop in core PAT.
• Bank Categories: Large private banks like ICICI Bank and Kotak Mahindra might experience less impact, while banks with lower NIMs and weaker RoA, such as IndusInd Bank and PSU banks, could face a higher impact.

 Broader Implications
IIFL Securities forecasts tighter LCR norms will lead to:

• Increased demand for Statutory Liquidity Ratio (SLR) bonds.
• Reduced loan-to-deposit ratios.
• Lower asset yields and increased competition for retail deposits.
• Potentially lower G-Sec bond yields.

 Conclusion

• The RBI’s new guidelines aim to strengthen banks' liquidity management in the face of evolving technological risks.
• While the rules are designed to enhance financial stability, they may add to the challenges banks already face with deposit growth and credit expansion.

Liquidity Coverage Ratio (LCR) Origin and Development Developed by the Basel Committee on Banking Supervision (BCBS), representing global financial centers. Proposed in 2010, finalized in 2014, with the 100% minimum requirement implemented from 2019.  Purpose Ensures financial institutions maintain a proportion of highly liquid assets to meet short-term obligations (cash outflows) over a 30-day period. The 30-day period aligns with the typical response time of governments and central banks during a financial crisis.  Definition The LCR is a stress test designed to confirm that banks and financial institutions have sufficient capital to handle short-term liquidity disruptions.  Understanding the LCR Ratio Formula Formula LCR = High-Quality Liquid Asset Amount (HQLA) / Total Net Cash Flow Amount Calculate by dividing the amount of high-quality liquid assets by the total net cash flows over a specific 30-day stress period.  What is HQLA? Definition High-Quality Liquid Assets (HQLAs) are assets that can be quickly and easily converted into cash.  Categories Level 1: Includes coins, banknotes, central bank reserves, and marketable securities. No discount applied. Level 2A: Includes securities issued or guaranteed by sovereign entities or multilateral development banks, and certain securities from US government-sponsored enterprises. 15% discount applied. Level 2B: Includes investment-grade corporate debt and publicly traded common stock. 25-50% discount applied.  Target Ratio Banks and financial institutions aim for an LCR of 3% or more, though they often maintain higher levels for added financial security.  Limitations of the Liquidity Coverage Ratio Increased Cash Holdings Requires banks to hold more cash, potentially reducing the amount available for issuing loans to businesses and consumers. Uncertainty in Crisis The true effectiveness of the LCR in providing adequate financial cushioning can only be assessed during an actual financial crisis, potentially after significant damage has occurred.

 

PRACTICE QUESTION Q. The Liquidity Coverage Ratio (LCR) is used to assess the ability of banks and financial institutions to manage short-term liquidity disruptions. Which of the following statements about the LCR is correct? A) The LCR is calculated by dividing total net cash flows by high-quality liquid assets. B) The LCR is calculated by dividing high-quality liquid assets by total net cash flows over a specific 30-day stress period. C) The LCR measures the ratio of capital to long-term liabilities. D) The LCR assesses the ability to manage long-term financial disruptions Answer: B) The LCR is calculated by dividing high-quality liquid assets by total net cash flows over a specific 30-day stress period.

 SOURCE: MONEY CONTROL