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FRM Part II · FRM Exam Part II · Liquidity Transfer Pricing: A Guide to Better Practice

A bank has a stable core deposit base that behavioral analysis shows will remain on average for about 4 years. The 4-year term funding cost is 3.20% on a liquidity-adjusted basis and the overnight rate is 1.00%. Under better-practice LTP, how should the treasury credit the deposit-gathering unit for 1,000 of these core deposits?

Credit the deposits at 3.20%. Better practice values liabilities by their behavioral life, and stable core deposits replace four-year wholesale funding the bank would otherwise buy. Using the overnight rate based on contractual maturity would undervalue the stable funding and weaken incentives to gather such deposits.

  1. ACredit at 1.00% because deposits are contractually callable on demand
  2. BCredit at 3.20% because the behavioral life supports a term-matched value to the bankCorrect
  3. CCredit at the average of 1.00% and 3.20%, 2.10%, to split the benefit evenly
  4. DCredit nothing, because deposits are liabilities that carry only a cost

Explanation

Liabilities should be valued by their behavioral, not contractual, maturity. A stable core deposit replaces 4-year funding the bank would otherwise buy, so the credit is 3.20%, or 32 on 1,000. Using 1.00% (contractual maturity) undervalues the stable funding and discourages deposit gathering.

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