FRM Part II · FRM Exam Part II · Liquidity Transfer Pricing: A Guide to Better Practice
A bank's LTP framework charges a flat liquidity cost to all credit lines regardless of drawdown likelihood. Business units then begin granting large committed undrawn facilities, because these are free to them. Which best-practice principle is the framework violating?
The framework violates the principle that contingent liquidity risk from off-balance-sheet commitments must be priced and charged to the originating business. Because undrawn lines can be drawn in stress and require a liquidity buffer, leaving them free encourages excessive commitments.
- AContingent liquidity risk, such as off-balance-sheet commitments, should be priced and charged to the originating businessCorrect
- BLiquidity charges should apply only to on-balance-sheet assets
- CTransfer prices should be set by business units themselves to reflect local conditions
- DLiquidity premiums should be fixed at inception and never revisited
Explanation
Undrawn commitments can create sudden liquidity needs under stress, so best practice charges for the contingent liquidity buffer they require. Restricting charges to on-balance-sheet items creates the very incentive problem described.
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