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

A bank's LTP policy sets the transfer charge on a 5-year term loan using the bank's own marginal cost of 5-year funding, which is 120 bps over the benchmark rate, while the credit given for a 5-year stable term deposit uses the same curve. A manager proposes using the average historical cost of all funding (60 bps) for both. Which is the main weakness of the manager's proposal?

The main weakness is that an average historical cost breaks the link to current marginal funding costs. New long-term assets would be charged 60 bps instead of the actual 120 bps, so they look more profitable than they are and encourage growth at uneconomic prices.

  1. AIt will always overstate the loan's profitability relative to market conditions in every period
  2. BIt breaks the link between the transfer price and current marginal funding costs, so decisions may add liquidity risk at uneconomic pricesCorrect
  3. CIt eliminates the need for a funds transfer pricing curve altogether, which regulators prohibit
  4. DIt makes the deposit credit higher than the loan charge in all cases

Explanation

Marginal cost reflects what it costs today to raise funds of that tenor. An average historical cost of 60 bps understates the current 120 bps cost, so new long loans appear more profitable than they are and the bank may grow them at uneconomic prices. The claim of 'always' overstating is wrong because averages can exceed marginal cost in other conditions.

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