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

A bank uses a single pooled funding rate for all assets regardless of their liquidity or tenor. The head of a lending unit notes that long-term illiquid loans are very profitable on a reported basis. What is the most likely incentive problem created?

Lenders will be encouraged to originate illiquid, long-tenor assets because a pooled rate understates their true liquidity cost. Reported profitability looks inflated, so liquidity risk builds up in the balance sheet without being charged to the business that created it.

  1. ABusiness lines will under-originate all assets because the pooled rate is too high
  2. BTreasury will be unable to calculate any funds transfer price
  3. CDeposit gatherers will be over-charged for liquidity they provide
  4. DLenders will be encouraged to originate illiquid, long-tenor assets because their true liquidity cost is underpricedCorrect

Explanation

A pooled rate ignores the higher liquidity cost of long-tenor, illiquid assets, so they look cheaper to fund than they are. This subsidizes illiquid lending and builds liquidity risk. Deposit over-charging is not the main issue, and a pooled rate can still be computed.

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