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

A bank's LTP framework has been criticised because the trading desk's inventory of liquid government bonds is charged the same liquidity premium as its holdings of structured credit, while the contingent liquidity buffer cost is allocated only to retail units. During a stress event, the bank finds the trading desk drew heavily on funding. Which reform best addresses this failure?

The best reform is to allocate buffer costs according to each unit's contribution to stressed liquidity needs and to differentiate charges by asset liquidity and funding horizon. This makes units that generate liquidity risk bear its cost, removing cross-subsidies, unlike pooling, uniform premiums or absorbing costs in treasury.

  1. AAllocate buffer costs based on each unit's contribution to stressed liquidity needs, and differentiate charges by asset liquidity and funding horizonCorrect
  2. BAbolish transfer pricing and fund all units from a single pool at the average cost
  3. CCharge all units the same premium to keep the framework simple
  4. DMove the buffer cost entirely to treasury so business lines are insulated

Explanation

Charges should reflect the liquidity risk each activity creates, including contingent draws under stress, so the party generating the risk bears the cost. Pooling, uniform premiums or absorbing costs in treasury all remove the incentive link and perpetuate cross-subsidies, as in the described failure.

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