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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 transfer rate equal to the weighted average cost of all funding for every asset and liability, regardless of tenor. Which outcome is most likely?

Long-term, illiquid assets will look more profitable than they really are, because a single pooled rate undercharges them for the cost of term funding. Business units are then incentivised to grow such assets, increasing the bank's maturity mismatch and liquidity risk.

  1. ABusiness units will be indifferent between short- and long-term assets, since all carry equal transfer costs
  2. BLong-term, illiquid assets will appear more profitable than they are, encouraging excessive maturity mismatchCorrect
  3. CShort-term assets will be penalised with the liquidity premium of long-term funding, reducing their volume only
  4. DDeposit gatherers will be unable to earn any credit for stable funding

Explanation

A pooled rate undercharges long-term illiquid assets relative to their true term funding cost, so they look more profitable and are overweighted, creating maturity mismatch. Business units are not indifferent, because revenue yields differ, and the pooled rate also overcredits or mis-credits liabilities.

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