What is the purpose of the liquidity coverage ratio (LCR) and how is it calculated?

• A. It measures profitability and is calculated as net income divided by total assets
• B. It compares total deposits to total cash on hand
• C. It equals high-quality liquid assets minus total net cash outflows
• D. It ensures banks hold high-quality liquid assets to cover net outflows for 30 days; LCR = high-quality liquid assets / total net cash outflows over 30 days

Answer: (D)

The main idea being tested is liquidity risk management: the bank must have enough easily liquid assets to survive a short-term stress scenario. The liquidity coverage ratio (LCR) is a tool Basel III uses to ensure banks can meet expected cash outflows over a 30-day period even under stress, by holding a buffer of high-quality liquid assets (HQLA).

The calculation is a simple ratio: the amount of high-quality liquid assets a bank holds divided by its total net cash outflows over the next 30 days. Net cash outflows are the estimated outflows minus inflows during the 30-day horizon under stress, with regulatory rules shaping how inflows are treated so the measure isn’t overstated. The higher the ratio, the better the bank’s liquidity position in a stressed scenario.

That’s why this answer is best: it states the purpose—to ensure banks hold sufficient HQLA to cover net outflows for 30 days—and it gives the correct formula, LCR = high-quality liquid assets divided by total net cash outflows over 30 days. The other options don’t describe this liquidity buffer or the ratio calculation.