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

A bank's treasury offers a business unit a committed credit line to a corporate client. The business unit argues no liquidity charge should apply because the line is undrawn and earns no funding cost today. Which approach is most consistent with good LTP practice?

Good practice charges the unit for the expected cost of liquidity buffers held against possible drawdowns, using stress-informed drawdown assumptions. Undrawn commitments still create liquidity risk because clients may draw in stress, so ignoring them or charging full notional at long rates would misprice the risk.

  1. ACharge the unit for the expected cost of holding liquidity buffers against potential drawdowns, based on stress-informed drawdown assumptionsCorrect
  2. BCharge nothing until the line is drawn, because only funded assets create liquidity cost
  3. CCharge the full committed amount at the longest term funding rate
  4. DExclude contingent exposures from LTP and handle them only through capital

Explanation

Contingent commitments create liquidity risk because drawdowns may occur in stress when funding is scarce. LTP should therefore price the cost of the buffer needed, using stress-informed drawdown estimates. Charging nothing misses the risk, while charging the full amount at long term rates overstates it and capital does not cover liquidity.

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