Recalibrate LCR Requirements
During Stress Periods

The Problem: Buffers That Cannot Be Used

The LCR was designed with a clear intent: banks should build liquidity buffers in good times that they can draw down during genuine stress. The Basel Committee's original design assumed banks would allow their LCR ratios to fall below 100% during a crisis, with supervisors accommodating such declines in recognition that the buffer was working as intended.

In practice, this has not happened. Supervisory culture and market scrutiny have made it functionally impossible for banks to let their LCR ratios fall. A bank reporting an LCR below 100% — even temporarily, even in a genuine stress period — faces immediate adverse market reactions and supervisory pressure. The buffer exists on paper but is structurally unusable in the scenarios it was designed for.

This dynamic forces banks to maintain permanent excess buffers above 100%, inflating structural reserve demand beyond what the LCR's designers intended. Industry data suggest LCR-subject banks in the U.S. consistently maintain LCRs of 125–160%, far above the regulatory floor.

The Policy Option

Two complementary approaches are discussed in the literature and by policymakers. The first is explicit regulatory flexibility: formally reduce the minimum LCR from 100% to some lower floor (such as 85% or 70%) during declared stress periods, similar to how the Basel framework envisions the buffer operating. The Fed and other U.S. banking agencies have occasionally communicated general flexibility, but a formal, pre-committed, quantitative floor with clear trigger conditions has never been established.

The second approach, advocated by Fed Governor Waller and others, is supervisory guidance reform: examiners would be explicitly instructed that a bank drawing on its LCR buffer is behaving prudently, not recklessly. Criticism of banks for temporary LCR declines during stress would be prohibited. This approach does not require a formal rule change but rather a shift in examination culture and off-site monitoring frameworks.

Quantifying the Buffer Premium

The gap between the theoretical minimum (100%) and the observed industry average (roughly 130–140%) represents a significant permanent buffer premium. If LCR-subject banks reduced their average LCR from 135% to 110% — still well above the regulatory floor — the aggregate reduction in HQLA demand would be substantial. Since reserves represent approximately one-third of HQLA, the reduction in reserve demand would be proportionally smaller but still material.

The paper notes the estimate of $50–200 billion is based on this partial pass-through from total HQLA relief to reserves specifically, and assumes regulatory and supervisory changes are credible enough to shift bank behavior meaningfully. Historical experience from the European Central Bank's similar interventions suggests behavioral change from supervisory guidance alone is slow, making formal rule changes more impactful.

Interaction with Stress Testing

Stress test (DFAST/CCAR) assumptions critically interact with LCR calibration. Stress tests often assume very large cash outflows over short windows, generating capital and liquidity demands that independently push banks to hold excess reserves. Without parallel reform of stress test liquidity shock assumptions, recalibrating the LCR minimum may have limited effect on aggregate reserve demand.

Implementation Considerations

Formal trigger conditions for the lower floor must be carefully designed to avoid perverse incentives. If banks can predict when the floor will be reduced, they may front-run the trigger, amplifying rather than dampening stress dynamics. Pre-committed, rules-based triggers tied to observable systemic indicators (e.g., Fed funds rate corridor width, overnight repo spreads) would be preferable to discretionary declarations. Coordination among the Fed, OCC, and FDIC would be required given the shared regulatory jurisdiction over LCR-subject banks.