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

A bank's LTP framework assigns a single flat internal funding rate to all loans regardless of maturity or the liquidity of the asset. A business unit is originating large volumes of 10-year illiquid project loans funded by overnight wholesale deposits. Which is the most likely consequence of this framework?

A flat internal funding rate undercharges long-term illiquid loans, so the unit's profitability is overstated and it is encouraged to originate more of them. The bank then builds up excess maturity mismatch and hidden liquidity risk, because the true cost of term and illiquid funding is not passed on.

  1. AThe unit's reported profitability is overstated and the bank accumulates excess maturity mismatch and liquidity riskCorrect
  2. BThe unit's reported profitability is understated and it will cut long-term lending
  3. CLiquidity risk is automatically reduced because a single rate simplifies funding
  4. DInterest rate risk is transferred to the unit through the flat rate

Explanation

A flat rate undercharges long, illiquid assets and overcharges short, liquid ones, so the long-term lending looks more profitable than it is. This encourages more mismatch and hidden liquidity risk. The understated profitability option reverses the direction of the mispricing.

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