Liquidity Buffer Choice Under LCR Pressure
You are the ALM manager at a bank with a €10bn balance sheet. The liquidity coverage ratio (LCR) is 118%, against a 100% minimum. The HQLA buffer is €1.2bn: 60% level 1 German government bonds, 30% level 2A covered bonds, and 10% level 2B corporate bonds. The 30-day stressed net cash outflow is €1.017bn. A financial-institution client offers a €250m three-month deposit at 3.5%. Under the LCR, financial-institution deposits have a 40% run-off factor. Alternatively, the bank can issue three-year covered bonds at 3.0% to fund €250m of loan growth. The loan growth would yield 4.2% and would be drawn immediately. The bank’s risk appetite requires LCR above 115% at all times. The treasurer wants to know which option is better for liquidity and profitability.
1. Calculate the pro forma LCR if the €250m financial-institution deposit is taken and held as level 1 cash. Show your workings.
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Current position
- HQLA = €1.2bn
- Net cash outflow = €1.017bn
- LCR = 1.2 ÷ 1.017 = 118.0%
Deposit held as level 1 cash
- New HQLA = €1.2bn + €0.25bn = €1.45bn
- Additional outflow = 40% × €250m = €100m
- New net outflow = €1.017bn + €0.1bn = €1.117bn
- Pro forma LCR = 1.45 ÷ 1.117 = 129.8%
So the deposit improves LCR if the cash is retained as HQLA. But note the critical alternative: if the €250m is used to fund loans rather than held as cash, HQLA stays at €1.2bn while outflows rise to €1.117bn. LCR would then be 1.2 ÷ 1.117 = 107.4%, which is above the 100% minimum but below the bank’s 115% risk appetite. The liquidity benefit depends entirely on retaining the proceeds.
2. Calculate the pro forma LCR if the covered bond is issued and the proceeds are used to fund the loan growth. Assume the loan growth creates no additional 30-day outflow and the covered bond has a 0% run-off factor.
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Covered bond issued and proceeds used for loans
- The €250m cash raised is immediately lent out, so it is not retained as HQLA.
- HQLA remains €1.2bn.
- The covered bond is three-year funding with a 0% run-off factor under the LCR assumption, so there is no additional 30-day outflow.
- Net cash outflow remains €1.017bn.
- Pro forma LCR = 1.2 ÷ 1.017 = 118.0%, unchanged.
Profitability
- Loan yield 4.2% − covered bond cost 3.0% = 1.2% net margin.
- Annual net interest income on €250m = €250m × 1.2% = €3.0m.
By contrast, if the €250m deposit is on-lent at 4.2% and costs 3.5%, the net margin is 0.7%, or €1.75m per year, and the LCR falls to 107.4% because the cash is not retained. The covered bond therefore supports loan growth without weakening the LCR, provided the loan does not create a 30-day outflow.
3. Recommend which option to choose, considering LCR, risk appetite, and profitability. State any conditions.
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Recommendation: choose the three-year covered bond to fund the loan growth, not the three-month financial-institution deposit, unless the deposit is explicitly retained as part of the liquidity buffer.
Reasons
- The covered bond keeps LCR at 118%, comfortably above the 115% risk appetite, while funding a profitable asset. It earns a 1.2% net margin, or €3.0m per year.
- The deposit only improves LCR to 129.8% if the cash is held as HQLA. If used for lending, LCR falls to 107.4%, below risk appetite. The deposit is also short-term, 40% run-off, and concentrated with a financial institution, so it is less stable funding.
- The covered bond is cheaper (3.0% versus 3.5%) and has a three-year tenor matching the loan growth better than a three-month deposit.
Conditions
- Confirm the loan does not create a 30-day outflow and that the covered bond is treated as 0% run-off under the bank’s LCR calculations.
- Check asset-encumbrance limits and investor demand for covered bonds before issuance.
- If the deposit is taken instead, ring-fence the proceeds as level 1 HQLA and monitor rollover risk; do not use it to fund illiquid loans.