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

A bank's LTP curve is built from the cost of 3-year senior unsecured issuance at 2.10% over the risk-free rate of 2.40%, giving 4.50%. A business unit originates a 3-year loan with an expected behavioural life of 3 years and also a committed undrawn line. Treasury later observes that, in a stress, the cost of 3-year issuance rises 150 bp. Which approach to the curve best aligns with sound LTP practice?

The curve should be updated to reflect current marginal funding costs, and undrawn commitments should carry a contingent liquidity charge. Fixing it at a stale level or using the lowest historical spread understates the true cost of liquidity and gives business units misleading incentives.

  1. AKeep the curve fixed at 4.50% to avoid volatility in business unit results, with no stress component
  2. BUpdate the curve to reflect current market funding costs and include a contingent liquidity cost for undrawn commitmentsCorrect
  3. CApply the 150 bp stress rise only to deposits, not to assets
  4. DSet the curve using the lowest observed historical funding spread to encourage lending

Explanation

Sound practice has the curve reflect current marginal funding costs and charges contingent liquidity costs for off-balance-sheet commitments such as undrawn lines. A fixed or lowest-historical curve understates true costs and mis-signals risk, and applying stress only to deposits is inconsistent.

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