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

A bank's LTP framework prices contingent liquidity risk from off-balance-sheet commitments. Which design feature is most consistent with better practice in allocating these costs?

Allocate buffer costs to the businesses that create the contingent exposures, using stressed outflow assumptions and the carry cost of holding liquid assets. Charging upfront aligns incentives with risk taken, whereas charging treasury, spreading evenly, or charging after the event leaves contingent liquidity risk unpriced.

  1. AAllocate the cost of the liquidity buffer only to the treasury, as it is the buffer manager
  2. BSpread the buffer cost evenly across all business units regardless of their commitments
  3. CAllocate buffer costs to the businesses that generate the contingent exposures, based on stressed outflow assumptions and the cost of holding liquid assetsCorrect
  4. DCharge only after a stress event occurs, based on the actual drawdowns observed

Explanation

Better practice charges the originators of contingent exposures ex ante for the cost of holding a buffer, using stress outflow assumptions and the negative carry on liquid assets. Allocating to treasury or evenly removes incentives, and charging after the event leaves risk unpriced when exposures are taken.

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