LCR Under Stress: Deposit Reclassification and a Downgrade Trigger
A bank reports the following at quarter-end (USD m): Level 1 assets 4,200; Level 2A assets at market value 900; Level 2B assets at market value 500. Run-off assumptions: stable retail deposits 8,000 at 5%; less stable retail deposits 3,000 at 10%; operational deposits 6,000 at 25%; non-financial corporate deposits without an operational relationship 4,000 at 40%; financial-institution deposits 1,500 at 100%. Undrawn committed corporate facilities 2,000 at 10%; undrawn liquidity facilities to banks 500 at 40%. Net derivative collateral outflow 150 and other collateral outflows 100. Contractual inflows from performing exposures are 950. Treasury proposes reclassifying USD 2,000m of retail deposits as 'stable' on the grounds that they are covered by deposit insurance. A rating agency has signalled a possible two-notch downgrade.
1. Compute the LCR, applying haircuts and testing each of the HQLA caps explicitly.
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HQLA.
- Level 1: 4,200 (no haircut, uncapped)
- Level 2A: 900 x 0.85 = 765
- Level 2B: 500 x 0.50 = 250
Cap tests:
- Level 2 total (1,015) versus 2/3 x Level 1 = 2,800 - not binding.
- Level 2B (250) versus 15% x total HQLA; uncapped total is 5,215, so 15% = 782 - not binding.
HQLA = 5,215.
Outflows (USD m).
| Item | Base | Rate | Outflow |
|---|---|---|---|
| Stable retail | 8,000 | 5% | 400 |
| Less stable retail | 3,000 | 10% | 300 |
| Operational deposits | 6,000 | 25% | 1,500 |
| Non-financial corporate, non-operational | 4,000 | 40% | 1,600 |
| Financial institutions | 1,500 | 100% | 1,500 |
| Committed corporate facilities | 2,000 | 10% | 200 |
| Liquidity facilities to banks | 500 | 40% | 200 |
| Derivative collateral | 150 | ||
| Other collateral | 100 | ||
| Total | 5,950 |
Inflows. 950 against a 75% cap of 4,462.5 - fully recognised.
LCR = 5,215 / (5,950 - 950) = 5,215 / 5,000 = 104.3%.
The headline looks compliant, but the surplus over 100% is only 215m, about 4% of net outflows. That is a thin margin for a bank whose largest single outflow bucket is 1,500m of 100% run-off financial-institution deposits.
2. Assess the proposal to reclassify USD 2,000m of retail deposits as stable. Quantify the effect and state the governance concerns.
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Mechanics. Moving 2,000 from less-stable (10%) to stable (5%) cuts the run-off by 2,000 x 5% = 100m. Net outflows fall to 4,900 and LCR rises to 5,215 / 4,900 = 106.4% - a gain of about 2.1 percentage points.
Is the classification defensible? Only if the deposits genuinely meet the stable criteria: covered by an effective deposit-insurance scheme, held in transactional accounts, with an established depositor relationship, and with no significant uninsured exposure of the same depositor to the bank. Retail customers who hold insured deposits alongside large uninsured balances do not behave as stable depositors. Insurance coverage alone is necessary but not sufficient.
Governance concerns.
- Materiality versus scrutiny. A 2pp gain is small relative to the supervisory attention that a 2,000m reclassification attracts. The trade is bad.
- Window dressing. If the reclassification is timed to the reporting date rather than reflecting the ongoing deposit base, it is worse than useless - it converts a liquidity question into a conduct and reporting question.
- It treats the symptom. The structural weaknesses are the 1,500m of 100% run-off financial-institution deposits and the 6,000m of operational deposits at 25%, both of which are concentration and stickiness problems that a retail reclassification does nothing about.
Better levers: lengthen wholesale funding to improve NSFR and reduce rollover concentration, diversify the financial-institution deposit base, and reduce reliance on operational deposits from a small number of large corporate clients.
3. Stress the position: the downgrade triggers USD 800m of additional collateral outflow and forces 600m of Level 2A to be sold or pledged. Recompute the LCR and outline the contingency funding response.
Read the worked answer
Recompute.
- Level 2A market value falls from 900 to 300, so post-haircut it contributes 300 x 0.85 = 255.
- HQLA = 4,200 + 255 + 250 = 4,705, a fall of 510 (the post-haircut value of the lost securities, not the 600 face amount).
- Outflows = 5,950 + 800 = 6,750; inflows remain capped at 950.
- Net outflows = 5,800.
LCR = 4,705 / 5,800 = 81.1% - a clear breach, driven roughly two thirds by the collateral call and one third by the HQLA loss.
Contingency funding response.
- What does not work: counting a committed backup line as HQLA. Drawing it is at best a conditional inflow and cannot be netted against the stress - that is double counting of the same liquidity.
- What does work, in order of speed: pre-positioned collateral at the central bank for same-day borrowing; selling the Level 2B book, recognising it is already haircut at 50% and will likely realise less in a stressed market; then term issuance.
- Covered bonds raise cash and lengthen the funding profile, which helps NSFR, but they encumber the mortgage book and reduce the unencumbered assets available for future secured borrowing and central-bank eligibility. That trade-off must be sized against the stressed HQLA need, not assumed away.
- Process point: the 800m downgrade outflow belongs in the CFP's early-warning indicators, triggered by the rating agency's signal, not discovered at the next reporting date. A bank that learns about its downgrade outflow from its own LCR return is already late.