The liquidity coverage ratio is a measurement required of banks so they can meet short-term financial obligations. Most countries heavily regulate banks and other financial institutions through a central bank or other source of laws and requirements. The liquidity coverage ratio is meant to cover short-term disruptions in a bank’s normal activities. For example, a central bank may require a specific amount of liquid assets in banks so these assets can cover copious withdrawals at one time. This coverage prevents the bank from being unable to meet these obligations and also prevents the government or central bank from having to bail it out.
Banks in most economies do not have to keep all the money they receive from deposits and other sources in their coffers. A central bank or other government regulations only require a small percentage to remain, with all other monies being available for loans and other financially rewarding investments. In the past, this caused trouble as bank runs — frantic periods when individuals attempt to pull all their money out of a bank — quickly depleted the cash assets. This panic can make it seem like a bank is failing, even when it is financially viable, as its money is placed into many types of investments. The liquidity coverage ratio helps prevent banks from experiencing these difficulties and others through retaining cash in the institution.
Countries may use any number of formulas to create a standard liquidity ratio for banks and other financial institutions. For example, the coverage ratio in the United States may require cash or Treasury bonds sufficient to meet withdrawals or other needs for a 30-day period. Banks and other financial institutions may only need this cash and short-term bonds to cover all deposits from customers at the institution. Other times, there may be another figure that is the base amount for the liquidity coverage ratio to meet in terms of potential cash withdrawals. Again, countries have the ability to design their own requirements for this ratio based on the current setup of its financial or capital markets.
In some cases, the liquidity coverage ratio may not be able to stop all bank runs or massive withdrawals in a short-term period. For example, if a bank or other financial institution has sufficient coverage for its normal deposits, it may lack enough cash for loans, which may be called by other institutions. When another bank calls a loan, the lack of cash may be a particular problem. In this scenario, banks may still need a lifeline from a central bank in order to meet these demands.