Updated May 11, 2016
The Liquidity Coverage Ratio and the Net Stable Funding Ratio
Issue Overview
Why Was Liquidity an Issue in the Financial Crisis?
Federal bank regulators have issued a final rule
Firms are unable to borrow if creditors believe, rightly or
implementing a liquidity coverage ratio (LCR) and a
wrongly, that they will not be repaid on time and in full. If
proposed rule implementing the net stable funding ratio
this happens widely, market demand for liquidity can
(NSFR) for large banks. This In Focus explains the
exceed private supply. A key feature of the financial crisis
rationale behind these liquidity rules and how they work.
was the sudden inability of financial firms, particularly
those reliant on short-term borrowing, to access liquidity
Liquidity
through private lending markets. Liquidity problems can
What Is Liquidity? Liquidity is a term that can apply to
cause a healthy firm to fail.
assets, markets, or firms. An asset is liquid if it is easily
bought and sold (i.e., converted into cash). Markets are
liquid if there are many ready buyers and sellers. A firm is
“As the financial crisis demonstrated, most of our
liquid if it holds liquid assets or has ample access to cash,
largest and most systemically important financial
and illiquid if it cannot sell (or borrow against) assets to
institutions used excessive amounts of short-term
raise cash.
wholesale funds and did not hold a sufficient amount
of high-quality liquid assets.... In the wake of the crisis,
From a bank’s perspective, holding liquid assets helps
regulatory bodies from around the globe convened to
ensure that it will reliably meet cash flow needs, which may
develop the first internationally consistent quantitative
be variable and unpredictable. The cost of holding liquid
liquidity standard for banking firms.”—Fed Chair Janet
assets is that they have a lower expected rate of return than
Yellen, September 3, 2014
less liquid assets, holding other characteristics constant. If
the primary function of banks is to transform deposits into
loans, the broader impact of requiring banks to hold more
Background
liquid assets is that they will hold fewer loans, which are
Why Were These Rules Adopted? In response to acute
generally illiquid. By contrast, requiring them to hold more
liquidity shortages and asset “fire sales” during the crisis,
deposits would not interfere with that primary function.
27 countries agreed in 2010 to modify the Basel Accords,
which are internationally negotiated bank regulatory
How Do Banks Access Liquidity? Banks may hold cash
standards. “Basel III” included liquidity standards for the
outright or as reserves at the Federal Reserve (Fed).
first time—the LCR, to ensure that banks have enough
Alternatively, banks can sell assets to meet cash-flow
liquid assets, and the NSFR, to ensure that banks have
needs, but to do so quickly the assets must be liquid. Banks
reliable funding sources in a stressed environment. The
can also borrow to raise cash, in some cases by pledging
LCR addresses the asset side and the NSFR addresses the
their assets as collateral. Banks can borrow from private
liability/equity side of the balance sheet.
investors through repurchase agreements (repos) or by
issuing commercial paper or bonds. Banks can also borrow
Basel III also includes capital requirements that the United
from other banks (e.g., through the federal funds market).
States has already implemented. In addition, the Dodd-
Alternatively, banks can borrow from public sources, such
Frank Act (P.L. 111-203) requires heightened prudential
as by obtaining advances from a Federal Home Loan Bank
or from the Fed’s discount window. Borrowing from the
standards, including liquidity standards, for banks with
more than $50 billion in assets and non-banks that have
Fed is minimal in normal market conditions.
been designated as “systemically important financial
institutions” (SIFIs).
What is the Difference Between Liquidity and Capital?
Banks hold capital to absorb unexpected losses, which
Who Is Subject to the Rules? The rules apply to two sets
cannot be borne by deposits or debt. If capital is entirely
of banks. A more stringent version applies to banks with at
depleted, liabilities exceed assets and a bank is insolvent.
least $250 billion in assets and $10 billion in on-balance
Banks face liquidity risk because they fund long-term assets
sheet foreign exposure. A less stringent version applies to
(e.g., loans) with short-term liabilities (e.g., demand
banks with $50 billion to $250 billion in assets, except
deposits). Some funding sources are more stable than
those with significant insurance or commercial operations.
others, and stable sources are relatively more costly,
At the end of 2015, the rules applied to only 35 institutions.
holding other characteristics constant. If a bank cannot
Although regulators examine all banks to ensure sufficient
borrow or sell assets to meet cash needs, it is illiquid. A
liquidity, these rules do not apply to credit unions or
bank can be illiquid without being insolvent, although
community banks. Further, regulators plan to issue liquidity
market concerns about the latter can cause the former.
regulations at a later date for large foreign banks operating
in the United States and non-bank SIFIs.
https://crsreports.congress.gov
The Liquidity Coverage Ratio and the Net Stable Funding Ratio
When Do the Rules Come Into Effect? The LCR came
How Many Banks Already Meet the NSFR Rule?
into effect at the beginning of 2015 and gets fully phased in
According to the proposed rule, “nearly all of these
at the beginning of 2017. The NSFR would come into effect
companies would be in compliance…today.” For firms not
at the beginning of 2018.
already in compliance, the regulators estimate a shortfall in
stable funding of $39 billion, or 4.3%, of weighted assets.
Liquidity Coverage Ratio
How Does the LCR Work? The rule aims to require banks
Policy Issues
to hold enough “high-quality liquid assets” (HQLA) to
Are the Rules Necessary? Because banks can always meet
match net cash outflows over 30 days in a hypothetical
their liquidity needs by borrowing from the Fed (or a
scenario of market stress where creditors are withdrawing
Federal Home Loan Bank), a case can be made that it is
funds. An asset can qualify as a HQLA if it has lower risk,
unnecessary to require banks to hold liquid assets. (Only
has a high likelihood of remaining liquid during a crisis, is
depository subsidiaries can borrow from the Fed, whereas
actively traded in secondary markets, is not subject to
the rules also apply to the holding company. Therefore, this
excessive price volatility, can be easily valued, and is
argument does not apply to the holding company.)
accepted by the Fed as collateral for loans. HQLA must be
Furthermore, borrowing from the Fed does not restrict
“unencumbered;” for example, they cannot already be
banks’ capacity to hold loans, whereas the opportunity cost
pledged as collateral in a loan.
of holding liquid assets is that it reduces the amount of
loans they can hold, all else equal. Both the Fed and other
Different types of assets are relatively more or less liquid,
policymakers have sought to discourage Fed lending in
and there is disagreement on what the cutoff point should
normal market conditions, however. These rules reduce the
be to qualify as a HQLA under the LCR. In the LCR,
likelihood that banks will need to borrow from the Fed.
eligible assets are assigned to one of three categories.
Assets assigned to the most liquid category are given more
Should the Rules Have Been Limited to Large Banks?
credit toward meeting the requirement, and assets in the
All banks—large and small—face liquidity risk, but these
least liquid category are given less credit.
rules apply only to the largest banks. The argument that the
rules would reduce the need for Fed lending is also
What Types of Assets Can Be Used to Meet the Rule?
applicable to small banks. In contrast, differences in the
HQLAs include bank reserves, U.S. Treasury securities,
funding structure of small and large banks mean that the
certain securities issued by foreign governments and
typical small bank has more stable funding than the typical
companies, securities issued by U.S. government-sponsored
large bank. According to FDIC data, small banks generally
enterprises (GSEs), certain investment-grade corporate debt
rely more heavily on deposits, which are viewed as a stable
securities, and equities that are included in the Russell 1000
source of funding, and less on “volatile liabilities” as a
Index. Securities issued by financial institutions do not
source of funding. (Not all deposits are equally stable,
qualify as HQLA, however, because regulators believe that
however.) Further, while banks of all sizes are susceptible
they are susceptible to becoming illiquid in a financial
to liquidity crises, crises at large banks are more likely to
crisis. The Fed permits some municipal bonds (issued by
have spillover effects that could pose systemic risk. For
state and local governments) to qualify in the least liquid
those reasons, the benefits of exempting small banks from
category, but the other banking regulators do not.
these rules may outweigh the costs, particularly if their
compliance costs are higher. Even if policymakers decided
How Many Banks Already Met the LCR Rule?
that small banks should be exempted, there is the issue of
According to a Fed memorandum, 70% of banks subject to
whether $50 billion is the ideal exemption level. For
the LCR already met its requirements. The Fed estimated
example, a 2011 FDIC study found that banks with assets
that, overall, banks that did not meet the LCR faced a
between $10 billion and $50 billion received a greater share
shortfall of $100 billion.
of funding from insured deposits than banks with more than
$50 billion in assets, but a smaller share than banks with
Net Stable Funding Ratio
less than $1 billion in assets.
How Does the NSFR Work? The rule would require banks
to have a minimum amount of stable funding backing their
Could the Rules Have Unintended Consequences?
assets over a one-year horizon. Different types of funding
Failure to maintain the required ratios could trigger a run if
and assets receive different weights based on their stability
creditors viewed it as a sign of weakness. Alternatively, if
and liquidity, respectively, under a stressed scenario. The
banks felt compelled (by regulators or for reputational
rule defines funding as stable based on how likely it is to be
reasons) to maintain the ratios during crises, it could result
available in a panic, classifies it by type, counterparty, and
in “fire sales” of illiquid assets, which could have spillover
time to maturity. Assets that do not qualify as HQLA under
effects for firms holding similar assets. Finally, if the
the LCR require the most backing by stable funding under
overall supply of HQLA is limited, the LCR could cause
the NSFR.
banks to buy up a significant fraction of those assets,
thereby reducing liquidity—and perhaps increasing
What Types of Funding Can Be Used to Meet the Rule?
volatility—in the markets for those assets. An estimated
Long-term equity gets the most credit under the NSFR,
70% of large banks already met the requirements, however.
insured retail deposits get the next most, and other types of
deposits and long-term borrowing get less credit.
Marc Labonte, Specialist in Macroeconomic Policy
Borrowing from other financial institutions, derivatives, and
certain brokered deposits cannot be used to meet the rule.
IF10208
https://crsreports.congress.gov
The Liquidity Coverage Ratio and the Net Stable Funding Ratio
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https://crsreports.congress.gov | IF10208 · VERSION 3 · UPDATED