Liquidity is a critical component of a bank’s financial stability and impacts its ability to meet short-term financial obligations and weather unforeseen economic challenges. Funding dynamics at banks of all sizes have evolved rapidly in the last few years and are the most interest-rate and event-sensitive since the 1980s. These evolving risks underline the importance of robust liquidity management. Considering recent bank failures, today’s bank regulators are scrutinizing liquidity arguably more than ever before.

Two essential liquidity calculations are the current focus of regulators: the liquidity coverage ratio (LCR) and the on-hand liquidity ratio (OHLR). Together, these two calculations help bank directors evaluate their risk exposure and make plans to strengthen their position if needed. Understanding the significance of these ratios also helps banks better prepare for regulatory audits.

Measuring the Ability to Cover Cash Needs Over Time
LCR measures a bank’s ability to cover liquidity needs as time passes. It compares high-quality liquid assets (HQLA) to projected net cash outflows over 30 days. Regulators use a simple equation to determine LCR health: LCR equals HQLA divided by total net cash outflows. The best practice is to maintain a ratio of 110%; less than 100% should trigger a contingency funding plan action.

HQLA comprises the sum of cash in interest-bearing accounts: federal funds sold, reverse repos and available-for-sale (AFS) securities. Then, the value of fed funds purchased, repos and pledged AFS securities are subtracted.

Essentially, a bank should be able to add up its liquid assets net of the liabilities secured by such assets. It should also apply haircuts related to the quality of assets. Basel III uses a 15% haircut on agencies and a 50% haircut on municipalities or corporates.

Cash flow modeling is more complex. Basel III guidance for banks over $100 billion stipulates uniform assumptions about cash outflow rates for major deposit categories. The analysis excludes liabilities already subtracted from HQLA as well as HQLA inflows.

Guidance caps inflows at 75% of forecasted cash outflows, ensuring a minimum HQLA “buffer” if inflows on loans are large relative to the assumed runoff of deposits. Cash inflows are mostly principal and interest payments on performing loans that the bank has no reason to expect will default within 30 days. Banks exclude contingent inflows from total net cash inflows.

Banks with less than $100 billion in total assets simulate liquidity coverage through stress testing cash outflow scenarios, rather than running one case using uniform assumptions. One example includes stressing liquidity levels and coverage with discrete cash outflow scenarios such as accelerated decay (i.e., run-off rates) of non-maturity deposits — particularly uninsured deposits and large depositor balances. Liquidity stress scenarios should include a forced sale of securities and the resulting estimated proceeds when this action is required to meet cash outflows.

Ensuring the Bank Can Satisfy Liabilities
OHLR is a point-in-time ratio, often called the primary liquidity ratio, which assesses a bank’s ability to satisfy liabilities with on-balance sheet HQLA. Some securities, like pledged securities, are not considered HQLA.

This ratio is HQLA divided by total liabilities. Regulators prefer a minimum of 25%, with less than 15% warranting a contingency funding plan action.

When evaluating liquidity, the asset type is critical and often confusing. For example, HQLA should not include securities classified as held to maturity (HTM) unless first reclassified to AFS and marked to market. If a bank includes HTM securities, there is a significant risk of tainting the HTM accounting at book value election. Securities a bank has already pledged also do not count. Banks may also consider valuation adjustments for securities.

Cash can be complex, too. A bank should not count vault cash for daily operating needs, but excess vault cash can. Balances that are temporary and essentially “due to” balances, such as intraday settlement, clearing balances and cash and coins in transit to clients, should not count toward liquidity.

Off-balance sheet liquidity does not count towards the primary liquidity ratio, but is considered a contingent funding source. A bank can include these secondary sources of liquidity in a total liquidity ratio.

Other key liquidity considerations include banks’ dependency on wholesale funding, which if used prudently, can diversify funding sources and enable a bank to increase primary liquidity.

While there’s no universal formula for determining the right level of liquidity for banks, these guidelines are crucial for managing liquidity effectively. Banks must consider their unique circumstances to maintain financial stability during times of uncertainty when liquidity is at a premium.