Learn with ETMarkets: Remember Silicon Valley Bank? Here’s why you should know about Liquidity Coverage Ratio (LCR)

Not long ago, the US witnessed a banking crisis that shook its financial landscape. Within a blink of an eye, Signature Bank, Silicon Valley Bank, and First Republic Bank crumbled, leaving many investors thinking over the causes of their downfall.

But who was the culprit behind these bank failures? Well, it was the dreaded bank run.

If we look at the Silicon Valley Bank, it faced an astonishing withdrawal of $42 billion in a mere 48 hours, leading to a depletion of its funds.

Yes, other factors also contributed to the collapse, such as loss on the sale of US treasuries. But let's set those aside and focus on the bank run itself.

In the aftermath of this turbulent episode, investors have become increasingly vigilant. They are actively seeking ways to analyse a bank's liquidity and want to ensure its ability to withstand adverse situations.

If you, too, are curious about how to assess a bank's resilience, look no further than the Liquidity Coverage Ratio (LCR).

It is a powerful metric that holds the key to understanding whether a bank possesses sufficient liquidity to shield itself from future storms.

What is Liquidity Coverage Ratio (LCR)?
The LCR is a safety net for banks ensured by RBI. It is a metric which tells us if a bank has enough assets to handle unexpected situations.

Basically, LCR is a requirement under which banks are required to maintain a certain amount of High-Quality Liquid Assets (HQLA) to cover outflows of 30 days.

So, LCR ensures that if lots of people suddenly want to withdraw their money from a bank, the bank will have enough cash to meet those demands and keep operating smoothly.

It's a way to protect the bank and its customers while maintaining stability.

How is the Liquidity Coverage Ratio Calculated?
The Liquidity Coverage Ratio (LCR) is determined by dividing the bank's high-quality liquid assets by its total net cash outflows.

High-Quality Liquid Assets (HQLA) are considered safe and are easily convertible into cash without significant loss in value. For example, HQLA includes cash, short-term bonds, and other cash equivalents.

It also includes the excess (over the mandatory requirement) Statutory Liquidity Ratio (SLR) and Marginal Standing Facility (MSF), which is a provision made by the RBI through which scheduled commercial banks can obtain liquidity overnight.

The total net cash outflow represents the expected amount of cash a bank would need to pay out during a stressful scenario over 30 days.

Here the bank considers its total cash outflows, such as customer withdrawals, operational expenses, and potential contingent outflows.

To calculate the LCR, the bank determines the value of its HQLA and assesses its net cash outflows under a stressful scenario. By comparing the two, the bank can determine its ability to withstand liquidity pressures and maintain sufficient liquidity to meet its obligations.

Interpretation of Liquidity Coverage Ratio
The RBI has set minimum LCR thresholds that banks must adhere to measure their liquidity strength and resilience. A high LCR shows that a bank is prepared for unexpected events and can handle financial challenges.

Let's look at a few banks' Liquidity Coverage Ratios (LCR) for the quarter ending March 2023:

• IDBI Bank has an LCR of 135.67%. This means that IDBI Bank has 135.67% of the required high-quality liquid assets to cover its net cash outflows over a 30-day period. In simpler terms, IDBI Bank is in a strong position when it comes to having enough liquid assets to handle unexpected situations.

• HDFC Bank has an LCR of 115.51%. This indicates that HDFC Bank has 115.51% of the necessary high-quality liquid assets to meet its expected cash outflows in times of stress. While slightly lower than IDBI Bank's LCR, HDFC Bank still demonstrates good liquidity to handle potential challenges.

• ICICI Bank has an LCR of 121.76%. This means that ICICI Bank holds 121.76% of the required high-quality liquid assets relative to its net cash outflows. Like HDFC Bank, ICICI Bank showcases a strong liquidity position, suggesting its ability to manage unforeseen circumstances effectively.

You can easily access the Liquidity Coverage Ratio (LCR) reports of banks on a quarterly basis. These reports are usually found in the regulatory disclosure section of the bank's website.

Other Ratios To Look at While Analysing Banking Stocks:

1. CASA Ratio
A bank's business model is simple: we deposit money in various accounts, and banks pay us interest based on those deposits. For example, current accounts have 0% interest, savings accounts offer 2-7% returns and fixed deposits pay around 7%. Banks then lend this money to others at a higher interest rate, say 10%.

The less interest they pay on deposits, the more profit they make. The CASA Ratio measures the proportion of deposits from current and savings accounts compared to fixed deposits.
A higher CASA Ratio leads to a lower overall cost of funds for the bank, which investors see as a positive.

A lower CASA Ratio indicates a heavier reliance on costlier funding sources like fixed deposits and market borrowings through bond/debt instrument issuances.

• Kotak Mahindra Bank’s proportion of CASA deposits decreased to 52.8% from over 60% compared to the previous year.
• HDFC Bank's proportion of CASA deposits also fell to 44.4% as of March 2023, down from 48.2% compared to the previous year.

One of the reasons behind the decline in CASA deposits can be attributed to higher interest rates during this period.

During times of higher interest rates, individuals tend to move their money to fixed deposits, which offer more attractive returns, while for banks, the situation is the opposite, i.e. they don’t want more deposits when interest rates go high, as it will increase their cost of deposits and cost of funds.

As a result, there is a deterioration in the proportion of CASA deposits.

2. Net Interest Margin (NIM)
In simple terms, net interest margin refers to the ratio of profitability of any bank or lending institution. It is calculated as the ratio of Net Interest Income and Average Interest Earning Assets.

Net Interest Income is the difference between the interest income a bank or financial institution earns from its interest-earning assets (such as loans, investments, balances with Central Bank and other banks and the short-term money market) and the interest expenses it incurs on its interest-bearing liabilities (such as deposits and borrowings). It measures how profitable a bank's lending and investment activities are.

Hence, Net Interest Margin = Net Interest Income / Average Interest Earning Assets (average of two consecutive quarters or years)

Hence, NII is basically the Gross Profit for banks. Interest-Earning Assets are a sum of all assets that generate interest income for a bank except fixed assets and other assets.

In the bank’s balance sheet, Interest Earning Assets are the sum of advances (the loan book), investments, balances they maintain with RBI, and balances kept with other banks and money markets.

For example, the Net Interest Margin of HDFC Bank was at 4.3% of total assets. This indicates 4.3% is the gross benefit of the lending funds for HDFC Bank.

Factors like interest rates influence net interest margin. When interest rates are low, people borrow more. This boosts banks' interest income, resulting in higher net interest margins.

Conversely, when interest rates increase, individuals prioritise saving and reduce borrowing. As a result, banks earn less interest income, leading to lower net interest margins.

To conclude, apart from the above-mentioned ratios, there are many other ratios that you must check, like Capital Adequacy Ratio, Slippage, Gross and Net NPA, P/BV etc.

By analysing all of these things, you will be able to analyse a bank better and make better investment decisions.

*The companies mentioned in the article are for information only. This is not investment advice.

(The author is Head of Research, TejiMandi)

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of Economic Times)