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Liquidity Coverage Ratio (LCR) - Indian Economy UPSC Notes

(LCR) is a financial rule that ensures banks and large NBFCs always have enough cash or cash-like assets to cover their short expenses during a crisis
Amith

Liquidity Coverage Ratio (LCR) Explained Simply with Example

What is LCR?

The Liquidity Coverage Ratio (LCR) is a financial rule that ensures banks and large Non-Banking Financial Companies (NBFCs) always have enough cash or cash-like assets to cover their short-term expenses during a financial crisis.

It is calculated as:

LCR=High-Quality Liquid Assets (HQLA)Net Cash Outflows over 30 days\text{LCR} = \frac{\text{High-Quality Liquid Assets (HQLA)}}{\text{Net Cash Outflows over 30 days}}

Where:

  • HQLA (High-Quality Liquid Assets): These are assets that can be quickly converted into cash without losing much value. Examples: Cash, Government Securities, Bonds issued by foreign governments.
  • Net Cash Outflows: The difference between expected cash outflows (money the bank must pay) and cash inflows (money the bank will receive) in the next 30 days.

Why was LCR Introduced?

After the IL&FS (Infrastructure Leasing & Financial Services) and DHFL (Dewan Housing Finance Limited) crises, the Reserve Bank of India (RBI) realized that many NBFCs and banks didn’t have enough liquid assets to handle sudden financial stress.

To prevent future liquidity problems, on 24th May 2019, RBI announced that large NBFCs must maintain a minimum LCR of 50% of net cash outflows starting from December 1, 2020. This means that NBFCs must always hold at least half of their next month's expected expenses in liquid assets.

Understanding LCR with a Simple Real-Life Example

Imagine you are a shopkeeper running a small business. You have monthly expenses like rent, supplier payments, and utility bills. You also earn money by selling products.

Now, let’s assume:

  • You need to pay Rs. 15,000 in the next 30 days (for rent, suppliers, etc.).

  • You expect to receive Rs. 5,000 from customers during the same 30 days.

  • Net cash outflow (total expenses minus expected income) = Rs. 15,000 - Rs. 5,000 = Rs. 10,000.

Now, suppose you have Rs. 6,000 in cash or assets (like emergency savings, gold, or government bonds) that you can easily convert into cash.

Why is holding Rs. 6,000 useful?

  1. Emergency Readiness – If there is a sudden delay in customer payments or unexpected expenses, you have some backup cash instead of borrowing money.

  2. Financial Stability – With Rs. 6,000 already available, you don’t have to struggle to arrange the full Rs. 10,000 immediately.

  3. Less Dependency on Loans – If you had zero savings, you would need to take a loan or credit, which could increase your debt.

Now, if you already have Rs. 6,000 in cash or assets that you can easily convert into cash (like emergency savings, gold, or government bonds), then:

LCR=High-Quality Liquid Assets (HQLA)Net Cash Outflows over 30 days×100\text{LCR} = \frac{\text{High-Quality Liquid Assets (HQLA)}}{\text{Net Cash Outflows over 30 days}} \times 100

Where:

  • HQLA (High-Quality Liquid Assets) = Cash, government securities, bonds, and other easily sellable assets.
  • Net Cash Outflows = Total expected outflows (expenses) minus total expected inflows (income) over 30 days.


LCR=6,00010,000=60%\text{LCR} = \frac{6,000}{10,000} = 60\%

This means you can cover 60% of your expenses for the next month without borrowing money.

Applying This to Banks & NBFCs

Just like a shopkeeper, banks also have regular cash outflows (loan repayments, customer withdrawals, salaries) and cash inflows (loan repayments from customers, investment returns).

If a bank's expected cash outflow is Rs. 100 crore and it holds Rs. 60 crore in cash & liquid assets, then:

LCR=60100=60%\text{LCR} = \frac{60}{100} = 60\%

This means the bank has liquid assets to cover 60% of its expenses for the next month—just like how the shopkeeper had Rs. 6,000 saved to cover part of his expenses.

Applying This to Banks

Banks and NBFCs also have expenses (loan repayments, salaries, withdrawals by depositors, etc.) and income (interest from loans, investments, etc.).

Let’s assume a bank has:

  • Expected Cash Outflows (Payments the bank must make): Rs. 150 crore
  • Expected Cash Inflows (Money the bank expects to receive): Rs. 50 crore
  • Net Cash Outflow = Rs. 150 - Rs. 50 = Rs. 100 crore

Now, suppose the bank holds Rs. 60 crore in High-Quality Liquid Assets (HQLA) (cash and government securities).

LCR=60100=60%\text{LCR} = \frac{60}{100} = 60\%

This means the bank has liquid assets to cover 60% of its expenses for the next month.

Key Takeaways

  1. LCR helps prevent liquidity crises by ensuring banks/NBFCs always have liquid assets available.
  2. RBI introduced LCR for NBFCs after IL&FS and DHFL crises to make the financial system more stable.
  3. Banks must hold HQLA worth at least a certain percentage of their net cash outflows to meet regulatory requirements.
  4. Higher LCR = More financial stability (e.g., an LCR of 100% means the bank has enough liquid assets to cover all outflows for 30 days).

This explanation combines both technical and simple real-life examples to make it easier to understand. Let me know if this helps! 😊

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