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

A bank's treasurer proposes using a single, firm-wide average funding rate for all internal transfers to keep the system simple. Business unit A holds mostly short-dated, liquid assets; unit B holds long-dated, illiquid assets. Which outcome is MOST likely?

Unit A will be overcharged and unit B undercharged, creating cross-subsidisation. A single average rate ignores differences in tenor and liquidity, so illiquid long-dated assets look cheaper to fund than they are, encouraging excessive illiquid risk-taking and misleading performance measurement.

  1. AUnit A is overcharged and unit B is undercharged, producing cross-subsidisation and distorted risk-takingCorrect
  2. BBoth units are charged accurately because averages cancel out
  3. CUnit B reduces illiquid assets because it is overcharged
  4. DUnit A earns excess funding credits for its liquidity

Explanation

An average rate exceeds the true cost of short-dated liquid assets and falls below the true cost of long-dated illiquid ones. This subsidises B at A's expense and encourages more illiquid asset accumulation. Averages do not cancel at the unit level, and B is undercharged rather than overcharged.

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