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

A bank's LTP framework charges contingent liquidity costs on off-balance-sheet commitments using stress-scenario drawdown assumptions. Over time, the business units observe that the contingent charge on committed facilities is high and begin to shift their lending toward uncommitted lines that attract no charge, even though the clients still expect the bank to fund them in stress. What is the most important weakness this reveals, and the best response?

The framework leaves a gap: uncommitted lines may still be funded in stress for franchise or reputational reasons, so avoiding the charge is arbitrage. Treasury should price expected behavioral drawdowns on them too, so charges follow realistic stress behavior rather than legal form.

  1. AThe charge is too high; treasury should remove all contingent charges
  2. BUncommitted lines carry reputational and franchise-driven draw risk; treasury should price expected behavioral drawdowns on them as well, consistent with actual stress behaviorCorrect
  3. CThe business units should be allowed to choose the lines since they bear the client relationship
  4. DThe bank should price committed lines using the overnight rate only

Explanation

Contingent charges must reflect the bank's realistic behavior in stress, not only legal commitment. If clients would effectively be funded anyway, leaving uncommitted lines uncharged creates an arbitrage and hidden liquidity risk. Removing charges or using overnight rates worsens misallocation.

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