Leading up to 2014, US banks increased their holdings of high quality liquid assets (HQLA) in part to comply with the liquidity coverage ratio (LCR) requirement. However, once the requirement was met, some banks shifted the compositions of their HQLA portfolios. This raises the question: What is the optimal composition of a given quantity of HQLA? Researchers from the Divisions of Research & Statistics and Monetary Affairs at the Federal Reserve Board use standard optimal portfolio theory to benchmark the ideal and find that a range of “optimal” HQLA portfolios is plausible depending on banks’ risk tolerance. A highly risk averse (inclined) bank prefers a relatively large share of reserves (mortgage-backed securities).
Of course, other factors interact with the LCR and influence banks’ management of the composition of HQLA. The research highlights several such factors, and show how the pattern of dispersion in the daily variance of banks’ HQLA shares may be influenced by them. We also describe an important implication of the LCR for the Federal Reserve’s longer-run implementation of monetary policy.