What is a liquidity coverage ratio (LCR)?

The liquidity coverage ratio (LCR) is a critical component of Basel III regulations, which were instituted to enhance the banking sector's ability to absorb shocks arising from financial and economic stress. The LCR specifically requires banks to hold an adequate level of liquid assets that can be easily converted into cash to meet their short-term obligations during a liquidity crisis, usually over a 30-day stress period.

This mandate aims to ensure that banks have sufficient liquidity to survive an acute financial downturn, enhancing the overall resilience of the financial system. The LCR is expressed as a ratio, comparing the amount of a bank's high-quality liquid assets to its total net cash outflows over a specified period. By adhering to this requirement, banks can manage liquidity risk more effectively and minimize the potential for financial instability.

The other options, while relevant to banking and finance, do not accurately define the liquidity coverage ratio. Minimum capital reserves relate to capital adequacy rather than liquidity specifically, company profitability is associated with measures like profit margins and return on equity, and market liquidity pertains to the ease with which assets can be bought or sold in the market, rather than a regulatory requirement like the LCR.