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

A bank's treasury finds that its business units systematically build long-term illiquid assets because the internal liquidity charge is set at a low blended rate, while the actual marginal cost of term funding in the market rose sharply. What is the most likely consequence?

The bank is likely to over-accumulate illiquid long-term assets and face funding gaps. Internal liquidity charges below the true marginal cost of term funding make such assets look artificially profitable, distorting incentives and increasing refinancing risk, so transfer prices must be updated to reflect market conditions.

  1. AThe bank over-accumulates illiquid assets and becomes exposed to funding gaps because internal prices understate true liquidity costsCorrect
  2. BThe bank under-lends because internal charges overstate market funding costs
  3. CDeposit-gathering units will cut deposit growth because liquidity credits are too high
  4. DBusiness units will shift to short-term assets because the term premium is too high

Explanation

If internal charges are below the marginal market cost of term funding, long illiquid assets look more profitable than they are. Units expand them, and the bank's funding gap and refinancing risk grow. The other options assume charges are too high, which contradicts the scenario.

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