The caps are shares of the capped total, so they bind on Level 1, and a euro of Level 2 above the line counts for nothing.
Under Basel III, Level 2 assets can make up at most 40 per cent of the stock of high-quality liquid assets after haircuts, and Level 2B at most 15 per cent; whatever exceeds the caps is simply not counted. Because the caps are shares of the final stock, they reduce to two limits on Level 1: Level 2 can be no more than two-thirds of Level 1 and, once that cap binds, Level 2B no more than a quarter of it. An illustrative bank with 4,800 million of Level 1 and 4,410 million of haircut Level 2 counts only 8,000 million, so its LCR is 80.0 per cent, not the 92.1 per cent a simple sum gives.
Worked in full in Financial Regulation by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The 1,210 million that falls out is not a haircut. Every euro of it is an eligible liquid asset, valued after its haircut, that the ratio refuses to see because there is not enough Level 1 underneath it.
| Asset | Level | Market value | Haircut | After haircut |
|---|---|---|---|---|
| Central bank reserves and 0% risk-weighted sovereigns | 1 | 4,800.0 | 0% | 4,800.0 |
| Covered bonds and 20% risk-weighted sovereigns | 2A | 3,600.0 | 15% | 3,060.0 |
| Corporate bonds, BBB+ to BBB− | 2B | 1,800.0 | 50% | 900.0 |
| Residential mortgage-backed securities | 2B | 600.0 | 25% | 450.0 |
| Simple sum after haircuts | 10,800.0 | 9,210.0 | ||
| Net cash outflows over 30 days | 10,000.0 |
The haircuts are the Basel III ones for these categories. The caps are applied to adjusted amounts, after unwinding short-term secured funding, secured lending and collateral swap transactions that mature within 30 days and involve the exchange of HQLA; this bank has none, so adjusted and reported amounts are the same. In the EU, Article 17 of Delegated Regulation (EU) 2015/61 keeps the same 40 and 15 per cent caps and adds a 70 per cent cap on extremely high quality covered bonds within Level 1, with the adjustment formula in its Annex I; haircuts and eligibility differ in detail between jurisdictions, so the local text governs.
HQLA = Level 1 + Level 2A + Level 2B − adjustment for the 15% cap − adjustment for the 40% cap
Adjustment for 15% cap = MAX(L2B − 15/85 × (L1 + L2A), L2B − 15/60 × L1, 0)
Adjustment for 40% cap = MAX(L2A + L2B − adjustment for 15% cap − 2/3 × L1, 0)
1,350.0 − 0.1765 × (4,800.0 + 3,060.0) = 1,350.0 − 1,387.1 = −37.1
1,350.0 − 0.2500 × 4,800.0 = 1,350.0 − 1,200.0 = 150.0
Adjustment = 150.0
3,060.0 + 1,350.0 − 150.0 − 0.6667 × 4,800.0 = 4,260.0 − 3,200.0 = 1,060.0
HQLA = 9,210.0 − 150.0 − 1,060.0 = 8,000.0
LCR = 8,000.0 / 10,000.0 = 80.0%
Excel: =L1+L2A+L2B-Adj15-MAX(L2A+L2B-Adj15-2/3*L1,0) with Adj15=MAX(L2B-15/85*(L1+L2A),L2B-15/60*L1,0)
The check is in the composition. Of the 8,000.0 counted, Level 1 is 4,800.0 (60.0 per cent), Level 2 is 3,200.0 (40.0 per cent) and, within it, Level 2B is 1,200.0 (15.0 per cent). Both caps bind exactly. The fractions come straight from the caps: if Level 2 may be 40 per cent of the total, Level 1 must be at least 60 per cent, so Level 2 can be at most 40/60, two-thirds, of Level 1. When the 40 per cent cap binds, the second leg of the 15 per cent test, 15/60 of Level 1, is the one that matters.
The bank is 2,000.0 short of 100 per cent, not the 790.0 the simple sum suggests. With the cap binding, one extra euro of Level 1 adds 1.6667 of HQLA, itself plus two-thirds of a euro of Level 2 that was already held but not counted. One extra euro of Level 2A adds nothing at all.
| Action | Size | HQLA after | LCR |
|---|---|---|---|
| Raise term funding (beyond 30 days) and hold it as reserves | 1,200.0 | 10,000.0 | 100.0% |
| Sell Level 2A bonds for cash, all of them | 3,600.0 | 9,750.0 | 97.5% |
| Sell the Level 2B corporate bonds for cash | 1,800.0 | 10,110.0 | 101.1% |
Selling Level 2A looks like the obvious fix and does not work. The first 797.8 sold lift the ratio quickly, to 93.3 per cent, because the cap releases two-thirds of a euro for each euro of new Level 1. After that the cap stops binding and each sale only recovers the 15 per cent haircut, so even selling every Level 2A bond leaves the bank at 97.5 per cent. Selling the corporate bonds works, because they carry a 50 per cent haircut: 1,800.0 of market value counted as 900.0 becomes 1,800.0 of Level 1. The assumption is that they sell at the valuation used; in a stress they may not. New term funding costs carry and needs 1,200.0, still far less than the 2,000.0 a pro rata reading of the shortfall would raise.
| Level 1 | Simple sum | HQLA counted | Excluded by caps | Simple LCR | LCR |
|---|---|---|---|---|---|
| 3,800.0 | 8,210.0 | 6,333.3 | 1,876.7 | 82.1% | 63.3% |
| 4,800.0 | 9,210.0 | 8,000.0 | 1,210.0 | 92.1% | 80.0% |
| 6,000.0 | 10,410.0 | 10,000.0 | 410.0 | 104.1% | 100.0% |
| 7,000.0 | 11,410.0 | 11,410.0 | 0.0 | 114.1% | 114.1% |
The caps stop mattering once Level 1 is at least 1.5 times Level 2, 6,615 here. Below that, HQLA falls faster than Level 1 does: losing 1,000 of reserves costs 1,666.7 of HQLA, which is why an outflow paid from reserves hurts a Level 2-heavy bank more than its headline ratio suggests.
Level 2 is only as good as the Level 1 beneath it. With the cap binding, the marginal value of Level 2 is zero and the marginal value of Level 1 is 1.6667. Treasury should know which side of the kink it sits on before it buys anything.
Compute the two adjustments, not just the sum: Level 2 is limited to two-thirds of Level 1 and Level 2B to a quarter of it when the larger cap binds. Here they take 1,210.0 out of the buffer and turn 92.1 per cent into 80.0. The most effective fix here, if the market holds, sells the asset with the biggest haircut. How long the buffer lasts once it is used is in how to calculate a bank's liquidity survival horizon, and both liquidity ratios are worked line by line in the free workbooks for Financial Regulation.
Level 2B assets, such as lower-rated corporate bonds, qualifying RMBS and equities, may be at most 15 per cent of HQLA after haircuts. In the formula the adjustment is the larger of L2B minus 15/85 of Level 1 plus Level 2A, and L2B minus 15/60 of Level 1. In the worked case that removes 150.0 million, leaving 1,200.0 million of Level 2B, exactly 15.0 per cent of 8,000.0.
Once the 40 per cent cap binds, any extra Level 2 is excluded in full, so its marginal value is zero. Only Level 1 lifts the ratio, and while the cap binds each euro of Level 1 adds 1.6667 of HQLA, because it also releases two-thirds of a euro of Level 2 that was held but not counted.
After haircuts, and after unwinding short-term secured funding, secured lending and collateral swaps that exchange HQLA and mature within 30 days. In the worked case haircut Level 2 is 4,410.0 million against 6,000.0 million at market value; testing on market values would report an LCR of 108.0 per cent against the correct 80.0.
This article is one calculation from Financial Regulation. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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