Basel III Liquidity Coverage Ratio and Net Stable Funding Ratio

Book: Financial Risk Management: Applications in Market, Credit, Asset and Liability Management and Firmwide Risk Authors: Jimmy Skoglund & Wei Chen ISBN: 978-1-119-13551-7

Chapter 6 closes with simplified liquidity risk measures and the Basel III regulatory framework. After 2008, liquidity got the same treatment capital got after earlier crises: hard minimum standards.

Cash Liquidity at Risk (CLaR)

When the hedging portfolio is cash-based, liquidity risk simplifies to a standard VaR on the risk reserve distribution. Skoglund and Chen call this Cash Liquidity at Risk (CLaR).

CLaR at confidence alpha and horizon T is the cash amount needed to stay solvent over T with probability alpha. It is monotone in time (unlike general liquidity measures) and consistent with the regulatory LCR.

Portfolio CLaR aggregates cash flows across business lines with netting of positive and negative flows within the portfolio.

Basel III: Liquidity Coverage Ratio (LCR)

LCR = stock of HQLA / net cash outflows over 30 days (stressed) >= 100%.

The numerator uses eligible assets with prescribed haircuts. The denominator applies runoff rates to different funding categories (retail deposits, wholesale, commitments) under a standardized stress scenario.

LCR is the short-term survival test. Can you survive a 30-day liquidity shock without central bank help?

Net Stable Funding Ratio (NSFR)

NSFR addresses structural maturity mismatch over a one-year horizon.

NSFR = available stable funding / required stable funding >= 100%.

It penalizes reliance on short-term funding for long-term assets. The goal is to prevent the Northern Rock model of borrowing overnight to fund long-term mortgages.

Monitoring metrics

Basel III also requires reporting on:

• Contractual maturity mismatch (gaps by time bucket)
• Funding concentration (dependence on a few counterparties or instruments)
• Available unencumbered assets (collateral you can still pledge)

These are early warning indicators, not binding constraints like LCR and NSFR.

Regulatory evolution

Basel liquidity guidance evolved from 14 principles (2000) to 17 principles (2008) to quantitative ratios in Basel III (2013). The shift from principles to hard numbers mirrors the capital ratio journey.

Link to FTP

CLaR and LCR-based costs feed into funds transfer pricing (Chapter 7). Products that consume liquidity should pay for it. Products that provide stable funding should get credit.

LCR mechanics in brief

Numerator: Level 1 assets at full value (with caps), Level 2A at 85%, Level 2B at 50%, subject to concentration limits. Denominator: 30-day net cash outflows with prescribed runoff rates on retail, wholesale, and operational deposits, plus drawdown assumptions on commitments.

Banks above 100% have a margin. Banks below must shrink mismatches or add HQLA. Reporting frequency and public disclosure turned LCR into a market signal, not just a supervisor checklist.

NSFR and maturity transformation

NSFR punishes funding long-term assets with unstable short-term liabilities. Available stable funding weights liabilities by stickiness. Required stable funding weights assets by liquidity drain. The ratio catches business models like originate-to-distribute funded overnight.

My take

LCR and NSFR are now as familiar as capital ratios for anyone in bank ALM. The book’s CLaR measure bridges internal economic thinking and regulatory compliance.

If you remember one thing: LCR is about surviving the first month. NSFR is about not building a balance sheet that needs rolling overnight funding to survive year one.

CLaR gives risk appetite language internally (“we need enough cash to survive 99% of 30-day scenarios”) that lines up with LCR externally. That alignment reduces fights between risk and treasury over buffer size.

European and US implementations differ in disclosure timing and phase-in schedules, but the core ratios are global. Banks operating in multiple jurisdictions map local reporting into one group liquidity framework. Skoglund and Chen treat Basel III as the common baseline even when national rules add buffers on top.

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