20 years: Research & banking
In this video January breaks down the Liquidity Coverage Ratio and explains its importance with a Northern Rock case study.
In this video January breaks down the Liquidity Coverage Ratio and explains its importance with a Northern Rock case study.
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18 mins 11 secs
Many banks tend to fund long-term lending commitments with short-term debt, hence creating a shortage of liquidity. The Liquidity Coverage Ratio was introduced to ensure banks have sufficient highly liquid assets to meet their short-term financial obligations.
Key learning objectives:
Discuss the different types of HQLA and the conditions in which they are traded
Explain the potential drawbacks of having a surplus of liquidity
Understanding the importance of Deposit Insurance Schemes, such as the FSCS in protecting deposits
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Liquidity is the ability and ease by which we can convert assets into cash. Typically, highly liquid assets would include money market funds, demand deposits, government notes and bonds. Whereas, illiquid assets include term deposits, property and other luxury goods lacking a public exchange.
The Liquidity Coverage ratio is expressed as the ratio of high-quality liquid assets to total net cash flows. Under Basel III, it applies to banks with over US $250bn in consolidated assets. Its main purpose is to ensure a bank has an adequate stock of HQLA that can be converted into cash in order to meet 100% of its liquidity needs under a 30-day stress scenario.
All assets listed above must be traded in large, deep and active repo or cash markets. They must have a proven record as a reliable source of liquidity in the markets. Further to this, it must not be an obligation of a financial institution or any of its affiliated entities. Level 1 assets may comprise up to 100% of a bank’s HQLA. Also, Level 2 assets may comprise no more than up to 40% of a bank’s reported HQLA after requisite regulatory haircuts.
Those considered ‘stable’ deposits are assigned a 3-5% run-off rate or higher. These are largely limited to retail deposits which include accounts held by individuals rather than LLP’s, or other business organisations. Furthermore, they must be fully insured by a certified deposit insurance scheme. Also, whether or not the customer has an established relationship with said bank. It must also be a transactional account whereby the customer has established direct deposits.
A ‘less stable’ deposit would include wholesale demand deposits, deposits not covered by an insurance scheme. These generally have a run-off rate of 10% or higher, and they include Operational deposits which receive a run-off rate of 25% or higher.
Bank’s drive basic economic activity when they take on deposits and lend them to other customers in the form of mortgages. From this, they earn interest and profit. Hence the emphasis on bank’s maintaining an adequate level of liquid assets could lead to institutions hoarding more cash than necessary. Similarly, it could curtail investment and spending, ultimately at the expense of potential economic growth and prosperity.
Financial Services Compensation Scheme in the UK and the Federal Deposit Insurance Scheme in the US are managed by government-sponsored entities that fund and compensate depositors when a financial institution has collapsed.
The FSCS restored customer confidence and trust in banks after the collapse of Northern Rock by increasing the insured amount an individual depositor can claim. At the time of the collapse, only £31,700 was protected. However, today the FSCS protects up to £85,000 per depositor, per institution. Additionally, it protects £170,000 per joint account per institution.
They also insure certain investments made by firms regulated by the PRA and FCA including:
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