FRM Part II · FRM Exam Part II

Liquidity Transfer Pricing: A Guide to Better Practice: formula sheet

Full chapter guide

Key formulas

Transfer price (conceptual build-up): Transfer price = base rate for the matching term + liquidity premium (+ contingent liquidity charge); This is a conceptual structure, not a fixed regulatory formula. The base rate covers interest rate risk; the premium covers the bank's term funding cost.
Business line margin after LTP: Net margin = customer rate − transfer price (for assets); transfer credit − customer rate paid (for liabilities); The business line earns the spread over the internal price. Treasury keeps the residual mismatch.
Matching principle: Transfer term = behavioural or contractual maturity of the product; Assets and liabilities are priced at the term of their liquidity profile. Use behavioural maturity when contractual maturity misleads, such as stable core deposits or prepayable loans.
Transfer price for an asset: Transfer price = matched-term funding rate (from the LTP curve) + liquidity premium for the asset's term and liquidity profile; Charged by treasury to the lending unit. Longer or less liquid assets get a higher charge.
Transfer credit for a liability: Transfer credit = matched-term funding rate (from the LTP curve) − liquidity discount for early-withdrawal risk; Paid by treasury to the deposit-gathering unit. Less stable deposits get a lower credit.
Business unit net margin after LTP: Net margin = customer rate − transfer price (assets); transfer credit − customer rate paid (liabilities); Shows the margin after liquidity cost. Compare it with margin before LTP.
Contingent liquidity charge: Charge = undrawn commitment × assumed drawdown rate in stress × liquidity cost rate; Illustrative structure, not a regulatory formula. The drawdown assumption comes from stress testing.
Funding charge on an asset: Charge = Balance × transfer rate at behavioral tenor; Use expected life after prepayment, not contractual maturity.
Funding credit on a liability: Credit = Stable balance × transfer rate at behavioral tenor + volatile balance × short-tenor rate; Split core and non-core deposits before assigning tenors.
Transfer rate build-up: Transfer rate = base funding curve rate + term liquidity premium; Premium should reflect the bank's own cost of term funding.
Contingent liquidity charge: Charge = Undrawn amount × stress drawdown % × buffer cost rate; Buffer cost rate = yield on funding minus yield on liquid assets.
Buffer carry cost: Buffer cost = Buffer size × (funding cost − liquid asset yield); This is the amount allocated to business units.
Buffer allocation: Unit share = unit stress outflow ÷ total stress outflow; Allocate by contribution to liquidity risk, not by size alone.
FTP rate for a tenor: FTP(t) = Base rate(t) + Liquidity premium(t); Base rate is risk-free or swap; premium reflects the bank's marginal term funding cost over base.
Liquidity premium: Liquidity premium(t) = Bank marginal funding yield(t) − Base rate(t); Includes the bank's credit spread and term premium. Use current, marginal cost.
Business unit net interest margin (matched): Margin = Customer rate − FTP(behavioural maturity); For a deposit, the credit is FTP(t) − Deposit rate.
Pooled rate: Pool rate = Total funding cost ÷ Total funds in pool; One average rate for all maturities; ignores tenor.
Weighted average FTP for multi-tranche funding: Σ(wᵢ × rateᵢ), where wᵢ = share of tranche i; Used for blending secured and unsecured funding costs.
Net liquidity result of a unit: Unit liquidity result = Liquidity credits on liabilities − Liquidity charges on assets − Charges for contingent exposures; A positive result means the unit provides net liquidity to the bank. A negative one means it consumes liquidity.
Funding charge on an asset: Charge = Internal LTP rate for the asset's term × Balance; Use the term or behavioral life of the asset, not the contractual funding actually used by the unit.
Cross-subsidy test: Cross-subsidy = Charge applied − Charge that reflects true liquidity cost; If the charge applied is lower than true cost, the unit is subsidised. If higher, it subsidises others.
Core governance rule: Board sets tolerance → ALCO approves policy and curve → Treasury operates → Risk and audit challenge; Know who approves, who runs and who challenges.

Quick revision

LTP allocates the cost and benefit of liquidity to the business units that create or use it.
Assets using funds pay a charge. Liabilities providing funds earn a credit.
Treasury is the internal counterparty that centralises liquidity management.
Price should match the liquidity profile and tenor of the product, not just its contractual maturity.
Contingent exposures, such as undrawn commitments, carry liquidity risk and should be priced.
Unpriced or underpriced liquidity encourages excessive growth in liquidity-consuming business.
Overpaying for deposits rewards gathering funds that may be unstable.
The curve combines a funding cost base with a liquidity premium that reflects stress costs.
Behavioural maturity, not only contractual maturity, matters for deposits and lines.
Transparency, regular review and clear ownership are core governance features.
Prices must be linked to performance measurement, or incentives will not change behaviour.

Common mistakes

Treating LTP and FTP as identical. Fix: Remember FTP is the whole internal funding charge, including interest rate risk; LTP is the liquidity component of it.
Thinking LTP is only a charge on assets. Fix: Remember liabilities that provide stable funding earn a credit, and contingent commitments carry a charge too.
Using one average funding cost for every product. Fix: Always read the rate off the curve at the product's term. A single rate subsidises long assets and penalises short ones.
Ignoring off-balance-sheet items such as committed credit lines. Fix: Remember comprehensive coverage includes contingent liquidity. Undrawn commitments can be drawn in stress and need a charge.
Using contractual maturity for the transfer rate. Fix: Use expected life after prepayments, and the stable share and observed behavior for deposits.
Treating all deposits as overnight funding. Fix: Split into core and volatile parts. Credit the core part at a longer tenor.
Using the bank's average historical funding cost as the curve. Fix: Use marginal, current cost of raising new funds at each tenor.
Using the risk-free curve alone with no liquidity premium. Fix: Always add the bank's liquidity premium, which includes credit spread and term premium.
Treating LTP as a Treasury-only technical exercise Fix: Remember that governance, ALCO approval and incentives decide whether LTP works.
Ignoring contingent liquidity risk Fix: Include a charge for contingent exposures such as credit lines and liquidity facilities. Their omission was a crisis-era failure.

Exam tips

Questions usually ask for the purpose: aligning incentives with risk appetite by allocating liquidity costs and benefits. Look for that wording.
Know the direction of flows: users of liquidity are charged, providers are credited.
Expect scenarios where one option uses a flat rate or lets business lines set prices. These are usually wrong.
Remember contingent liquidity risk, such as undrawn commitments and buffer costs, is part of a complete framework.
Treasury's central role and board-level governance often decide between two plausible answers.
Name the principle precisely: comprehensive coverage, matched-term pricing, transparency or consistency with risk appetite.
Contingent exposures such as undrawn commitments are a favourite trap. If the question mentions them, coverage is likely the answer.
In calculations, check the term and the direction of the flow before you subtract.