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

A bank's lending desk originates a 5-year fixed-rate bullet loan funded in the market. The treasury charges the desk a transfer price based on the bank's 1-year funding curve, rolled over each year. Which is the most significant weakness of this approach under good LTP practice?

Pricing a 5-year loan off a 1-year funding rate fails to charge the desk for term liquidity, so profitability is overstated and refinancing risk stays with treasury. Good LTP practice matches the transfer price to the asset's tenor, so incentives reflect the true cost of long-term funding.

  1. AThe desk is not charged for the term liquidity risk, so the loan appears more profitable than it truly is and the bank bears the refinancing risk centrallyCorrect
  2. BThe desk is overcharged because the 1-year curve is always above the 5-year curve
  3. CThe approach double counts credit spreads on the loan
  4. DThe approach makes the loan ineligible for central bank collateral

Explanation

Charging a short-term rate for a long-dated asset understates the term funding cost when the curve slopes upward and leaves refinancing risk with treasury. Good practice matches the transfer price to the behavioral or contractual tenor of the asset. The claim that the 1-year curve is always higher is incorrect.

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