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

A bank uses a single, flat one-year funding charge for all loans regardless of maturity. The business unit originating 10-year bullet loans funded by the central treasury reports high profitability, while the unit gathering 5-year term deposits reports low profitability. What is the most likely flaw in the LTP framework?

The likely flaw is that a flat one-year charge ignores maturity and liquidity characteristics. Long-dated loans are undercharged for the term funding they need, and term deposit gatherers are not credited for stable funding, which distorts profitability and encourages excessive long-term lending.

  1. AThe charge ignores the maturity and liquidity characteristics of the assets and liabilities, so long-term liquidity costs are not passed to the loan originatorsCorrect
  2. BThe framework uses matched-maturity pricing, which overcharges long-term loans
  3. CThe framework allocates too much contingent liquidity cost to deposit gatherers
  4. DThe charge is based on the bank's marginal cost of funds at the correct tenor

Explanation

A flat short-term charge understates the cost of funding long assets and undervalues long-term stable funding. Loan units look profitable and term deposit gatherers are not rewarded for stable funding. Matched-maturity pricing would correct, not cause, this distortion.

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