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

A bank's treasury operates a funds transfer pricing framework that follows the principles of better practice for liquidity transfer pricing. A business unit originates a 5-year fixed-rate loan funded by the central treasury. Which liquidity charge is most consistent with those principles?

The loan should be charged a liquidity cost based on term funding matched to its expected liquidity profile. This passes the true cost of funding long-dated assets to the originating unit, avoiding the cross-subsidies and distorted incentives that overnight or pooled average rates create.

  1. AA charge based on the bank's overnight funding rate, because the loan is funded daily
  2. BA charge reflecting the cost of term funding matched to the loan's expected liquidity profileCorrect
  3. CA charge equal to the average cost of all the bank's funding, regardless of loan tenor
  4. DNo charge, because liquidity costs belong only to the treasury function

Explanation

Better practice requires that assets be charged a liquidity cost reflecting the term and liquidity characteristics of the asset. Overnight rates understate the cost of a 5-year asset, and a pooled average rate hides the tenor differences and gives wrong incentives.

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