How much does liquidity and LCR cost?

25.6.2011 par Gilbert Issard.

The answer seems pretty obvious and straightforward: liquidity costs the spread between the Interest Rate Swap (IRS) rate and the senior unsubordinated debt rate. It is the liquidity spread, or liquidity premium. This is how a liquidity curve is build.When we talk of borrowing 3 years at EURIBOR + 80 basis point (or bp) it just means that 3 year fixed rate minus the 3 year IRS rate is 0.8%.

IRS do not bring liquidity but are pure interest rate products, making it possible to split the debt interest rate between liquidity and interest rate risk. This is of course true, but there is another liquidity cost, which is of different nature, and often not properly analyzed nor measured: the liquidity insurance cost.

LCR, or any other measure such as the french liquidity regulatory ratio (coefficient standard de liquidité)  for which a minimum level has been set by regulators that must be satisfied by banks carry a cost: namely the cost of satisfying such measures. This cost is of different nature than the liquidity spread. It is not a cost of borrowing, but rather an insurance cost.

This can be deducted directly from Basel III liquidity paper and more precisely paragraph 4:

The first objective is to promote short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets to survive a significant stress scenario lasting for one month. The Committee developed the Liquidity Coverage Ratio (LCR) to achieve this objective.

Holding very liquid assets bears  a cost which is an insurance cost, the insurance that banks with a LCR greater than 100% will survive a significant liquidity stress, be it a stress on the bank only (reputational) or the whole market.

There is no agreed formula to calculate this cost, but it can be evaluated as the cost of  borrowing at a significantly longer term than the stress horizon (let us 3 months in the case of LCR) minus the income the buffer of liquid assets yields. It then depends on the ‘liquidity insurance strategy’ of the bank. This cost can be optimized depending on what tenor the bank is using to fund the liquid assets buffer, and what assets are hold as a liquidity buffer.

I too often see confusion between these 2 costs. It must be clearly understood that there are 2 liquidity costs: 1) an funding cost measured by the liquidity spread or premium, and 2) an liquidity insurance cost.

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