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

A bank's treasury charges its lending desk a flat funding rate equal to the three-month interbank rate for all loans, including 10-year illiquid project loans. Deposit-gathering units are credited the same flat rate for all deposits, including stable long-term ones. What is the most likely behavioural outcome?

Lending desks will favour long, illiquid loans and deposit units will favour short, volatile funding. A flat short-term rate undercharges illiquid assets and fails to reward stable funding, so incentives push the bank toward a larger liquidity mismatch.

  1. ALending desks will favour long, illiquid loans and deposit units will favour short, volatile funding, increasing the bank's liquidity mismatchCorrect
  2. BLending desks will shorten loan maturities because funding looks expensive
  3. CDeposit units will concentrate on stable long-term deposits because they are rewarded most
  4. DThe bank's structural liquidity position will improve automatically

Explanation

A flat short-term rate undercharges long illiquid assets and under-rewards stable long-term funding. Business lines respond by writing more long loans and gathering cheaper-to-source short funding, widening the mismatch. The other outcomes assume prices that reflect liquidity cost, which this flat rate does not.

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