High Quality Liquid Assets (HQLA)

What are High Quality Liquid Assets and how are they helpful?

The term ‘High Quality Liquid Assets’ refers to those securities which can be quickly converted to cash, without a significant change in their value. These are usually those financial assets which have a very low risk associated with them.

These types of assets gained popularity after the Basel-3 norms for banks and finance companies were proposed. The HQLA in banking is primarily needed to cover any cash outflows during stressful times.

The ‘Liquidity’ aspect in the term HQLA indicates that the asset can be easily sold in the market. Whereas the ‘High Quality’ part is judged by the ability of the asset to keep its value, in case of a distressed sale. This means that if the price of the asset drops when it is sold in stressful market conditions, then it is considered to be of low quality.

Need for High Quality Liquid Assets

Sometimes, the businesses might face a situation where they are in a sudden need for capital. If liquid funds are not available at that instant, then the business might need to sell some of their assets.

The main purpose of holding High-Quality Liquid Assets is that these can be quickly converted to cash. This will help the business to meet any short-term obligations/liabilities. It also provides a safety-net against any unforeseen financial crunch.

In many countries, the Central Banks define regulations related to the ownership of such liquid assets. For example, the banks might be required to hold HQLAs, which are sufficient to survive at least 30 days of financial stress.

Maintaining Liquidity Coverage Ratio

The Liquidity Coverage Ratio (LCR) refers to the percentage of assets of a company that should be highly liquid. This liquidity is needed in order to meet any short-term financial obligations. The HQLA is primarily used for maintaining this holding requirement.

The portfolio of High Quality Liquidity Assets for a bank should be well diversified, and have different securities. If majority of the assets are Government Securities, then they should preferably have different maturities. The idea is to avoid concentration in a particular security, so that there is no shock in case of a market stress.

Levels in High Quality Liquid Assets

In many regions, the High Quality Liquid Assets are usually categorized into 2 (or more) categories/levels. These are normally called Level 1 assets and Level 2 assets. The prime difference between them is the safety that is offered by the asset.

The Level 1 assets are considered to be more liquid, and to have higher quality. This means that they can be easily sold in the market, and keep their value in stressful situations. The Level 2 assets on the other hand have a comparatively lower liquidity and quality. So, they could lose a little value when they are sold in stressful times.

Since they are of higher quality, the Level 1 assets can usually be carried at full and exact value on the Balance Sheet. Whereas the value of Level 2 assets has to be adjusted downwards in calculations, because they could lose some value at sale time. For example, the Level 2 assets could be required to have a Haircut of 15%, when they are shown as HQLAs.

High Quality Liquid Assets example

There are many types of assets that are considered to be liquid, and have a high quality. Ideally, each entity should hold a mixture of these assets, in order to properly diversify the risk.

Sometimes, the regulatory bodies define guidelines related to the maximum and minimum quantity of assets that a company should own. For example, the banks might have to hold at least 60% Level 1 HQLAs, which have a higher quality than Level 2 assets. The High Quality Liquidity Assets include the following financial instruments.

1. Cash and Cash Equivalents

Perhaps the most obvious and popular High Quality Liquid Asset is the Cash that is held by an entity. The liquid cash is considered high quality because it can be used right away, and conversion/sale/liquidation is not applicable. Although Cash loses its value over long duration due to the concept of Time Value of Money, but it is very efficient in meeting short-term obligations.

2. Government Securities (G-Secs)

The securities issued by the government are usually considered to have the lowest risk of default in any region. That is a primary reason why there is a huge demand for such securities. These could include both long-term and short-term securities like Government Bonds, Treasury Bills (T-Bills), State Development Loans (SDLs), Cash Management Bills (CMBs) etc.

Since large quantities of these securities are easily tradeable in the market, they can be quickly and easily liquidated when required.

3. Central Bank Reserves

In the banking industry of many regions, the banks and Non-Banking Finance Companies (NBFCs) have to park certain quantity of their funds with the Central Bank. These show up as Reserves on the Balance Sheet of the banks. The idea behind keeping this buffer capital with the Central Bank is that these funds can be used during times of stress.

So, these are considered as an HQLA, because they have a low risk, and they can be used when required. The minimum size of these reserves is usually governed by the Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) and other Reserves that are prescribed by the Central Bank.

4. Debt securities with zero or low risk

There are some debt securities that have not been directly issued by the government, but they have the support of the government or the Central Banks. This will usually increase the demand for these assets, and make them less risky.

For example, suppose that there is a bond with a strategic social purpose, and it has been backed by the Sovereign Guarantee of the Central Government. So, the chances of default in this type of Debt will be considerably lower.

5. High quality Corporate Bonds

Some debt that has been issued by private companies or Public-Sector Undertakings (PSUs) could be considered as a High-Quality Liquid Asset as well. These could include instruments like Bonds, Non-Convertible Debentures (NCDs), Commercial Papers etc.

Only the companies which have a very High Credit Rating, are usually considered to be safe. But this type of Debt will still be riskier than the Government Securities. Debt securities with lower Credit Ratings could also be included, but with a higher Haircut in their value.

For example, Debt instruments that are rated ‘AA’ or higher might require a 15% Haircut in value. While Debt with a rating below ‘AA’ might need a 50% Haircut. At the same time, Junk Bonds might not be included at all.

6. Other instruments

Depending on the regulatory guidelines in the region, some other types of securities can be added to the HQLA list, with a different percentage of Haircut on carrying value. For example, some Structured Finance Obligations like Mortgage-Backed Securities (MBS) could be kept on the Balance Sheet, with a 50% Haircut in value.

Sometimes, the Equity that is trading on the Stock Exchange is also considered as a High-Quality Liquidity Asset. But this is usually included with a very large Haircut on the market value of the stock.

Example: Suppose that a bank holds Equity Shares of a Blue Chip company, worth INR 20,00,00,000 (INR 20 crore). The Central Bank might allow 50% of this holding (INR 10 crore) to be included in the HQLA calculations of the bank.

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  • Some information could be outdated / inaccurate
  • Investors should always consult with certified advisors and experts before taking final decision
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