TAG: GS 3: ECONOMY
THE CONTEXT: The Reserve Bank of India (RBI) has announced its intention to review the Liquidity Coverage Ratio (LCR) framework to enhance liquidity risk management by banks.
EXPLANATION:
- This move comes in response to recent incidents in various jurisdictions highlighting the increased ability of depositors to swiftly withdraw funds during times of stress using digital banking channels.
- RBI Governor emphasized the need to reevaluate certain assumptions under the LCR framework in light of emerging risks posed by digital banking channels.
- The ability of depositors to quickly withdraw or transfer funds during periods of stress underscores the importance of ensuring that banks maintain adequate liquidity to meet their obligations.
Liquidity Coverage Ratio (LCR) Framework
- The liquidity coverage ratio (LCR) refers to the proportion of highly liquid assets held by financial institutions, to ensure their ongoing ability to meet short-term obligations.
- This ratio is essentially a generic stress test that aims to anticipate market-wide shocks and make sure that financial institutions possess suitable capital preservation, to ride out any short-term liquidity disruptions that may plague the market.
- The LCR was introduced as part of the Basel III reforms following the 2008 global financial crisis and was finalised by the Basel Committee on Banking Supervision in January 2013
- LCR = High-Quality Liquid Asset Amount (HQLA) / Total Net Cash Flow Amount
- Under the LCR framework, banks are mandated to maintain a stock of high-quality liquid assets (HQLA) to cover their net cash outflows over a 30-day period under stressed conditions.
- These liquid assets include cash, short-term bonds, and other cash equivalents.
- The LCR requirement encompasses excess SLR and Marginal Standing Facility (MSF), which serves as an emergency liquidity window provided by the RBI to banks for obtaining overnight liquidity.
- Banks have been required to maintain an LCR of 100% since January 1, 2019.
- Additionally, all assets eligible under the SLR are permitted to be counted as HQLAs for meeting the LCR requirement.
Need for Redefining LCR
- Recent incidents involving US-based banks experiencing significant fund withdrawals within hours via digital channels have highlighted the need to reassess the LCR framework.
- While the 100% LCR limit is not expected to be adjusted, there may be revisions in the treatment of various asset classes under the LCR framework.
- The necessity for periodic reviews of LCR stipulations to ensure their effectiveness in addressing evolving risks and market dynamics has been emphasized.
Expected Outcomes of the Review
- The RBI’s review of the LCR framework may lead to adjustments in the treatment of different asset classes, either through relaxation or tightening measures.
- The objective is to ensure that banks maintain sufficient liquidity buffers to withstand potential stress scenarios effectively.