Different views of the liquidity reserve
Published: 9 May 2022
The liquidity metrics LCR and NSFR define a liquidity reserve; that is, the assets that are considered able to generate immediate liquidity, no matter what their maturity is. An example is a government bond that might have a maturity of several years, but which is nevertheless considered liquid because the bank has good prospects of converting it to liquidity immediately. Whether or not an asset is liquid in these metrics is closely correlated with the credit risk. If the credit risk is sufficiently low, the asset is considered liquid. One reason for this is that the central banks largely proceed on the basis of credit risk when determining which assets are eligible as collateral for the banks to pledge to enable them to borrow from the central bank.
An effect of defining the liquidity of an asset using credit risks is that an asset’s maturity becomes less important to its liquidity. As mentioned earlier, maturity can be of significance, for example for lesser dependence on the central bank, and for this reason the DLC metric is based on maturity to judge the liquidity of an asset despite the fact that assets eligible for pledging with a central bank are more liquid than indicated by their maturity. DLC is a good point of departure for analysing liquidity risks as the metric is relatively simple and based on few assumptions. On that basis, adjustments can then be made to the DLC metric to gain further understanding of the liquidity risk in a bank.
If the DLC metric is adjusted so that all assets which are liquid according to LCR are considered liquid from day one irrespective of maturity, this nevertheless does not cause any change to the time buckets for the local maximum and minimum in Diagram 4. The curve shifts upwards but the shape is the same. The conclusion is therefore maintained that the banks optimise their liquidity position according to these metrics.