Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 15. Liquidity Transfer Pricing

Presented by: Sudhanshu

Module 1. Best Practices and Challenges for Liquidity Transfer Pricing

Module 2. Approaches for Liquidity Transfer Pricing and Contingent Liquidity Liquidity Risk Pricing

Module 1. Best Practices and Challenges for Liquidity Transfer Pricing

Topic 1. LTP Process

Topic 2. Best Practices for Governing the LTP Process

Topic 3. Challenges of Implementing the LTP Process

Topic 1. LTP Process

• What is LTP?

  • LTP is the process of allocating the costs, benefits, and risks of liquidity to a bank's different business units.

  • It should be managed centrally by a group treasury.

• Why is LTP Important?

  • Poor LTP practices were a contributing factor to the liquidity issues during the global financial crisis.

  • A 2009 survey of 38 banks in 9 countries revealed numerous deficiencies in LTP, which this reading aims to address with suggestions for improvement.

  • Proper LTP is essential to prevent banks from accumulating illiquid long-term assets funded by short-term sources that may not be available during a crisis.

• The LTP Process

  • Centralized Treasury Model: The central treasury should oversee all wholesale funding.

    • Business units that create loans (assets) are charged a liquidity premium for funding costs.

• Business units that generate deposits (liabilities) are credited for providing liquidity.

• Trading business units are charged for the use of funds for contingent commitments, such as derivatives and collateral calls. Conversely, they receive credits for providing funds through the sale of marketable securities.​

• Funding Rates

  • Liquidity funding rates should be based on the bank's marginal cost of funds and matched to the product's maturity.

  • Historically, the LIBOR/swap curve was the common reference rate, but an alternative like the secured overnight financing rate (SOFR) will be used in the future.

• Shortcomings in LTP Prior to the Global Financial Crisis

  • Decentralized Structures: Many banks had decentralized funding structures with weak internal controls, which required manual adjustments and resulted in poor management oversight.

  • Inadequate Systems: Liquidity management information systems (LMIS) could not compute the costs, benefits, and risks of liquidity at a granular level for all business units.

  • Misaligned Incentives: Employee and business unit managers' rewards were based on inflated profits that did not properly account for liquidity funding costs and risks.

• ​Flawed Pricing Approaches:

  • The zero-cost and average cost funding approaches significantly underpriced the cost of liquidity for illiquid long-term assets.

  • These methods did not provide adequate credit for liquidity providers.

• Underestimation of Risk:

Stress tests were not used to determine the necessary size of a liquidity cushion for off-balance-sheet risks and systemic shocks.

Banks relied on overnight or short-term funding for illiquid long-term assets, underestimating the true cost of liquidity.

Practice Questions: Q1

Q1. Which of the following is considered a best practice of liquidity transfer pricing (LTP)?

A. A centralized treasury funding center should be implemented to manage the liquidity cushion across business units.

B. Banks should rely on external factors to improve LTP by meeting regulatory authority requirements.

C. Remuneration policies should not be linked to LTP to help incentivize business unit managers to produce longer-term assets.

D. Contingent collateral calls and derivatives should not be included in the LTP process but managed separately to properly account for risks.

Practice Questions: Q1 Answer

Explanation: A is correct.

A centralized funding center is necessary for proper internal governance of the LTP process. Wholesale funding should be restricted to a group or subsidiary treasury. Internal factors play an important role in effectively managing the LTP process. Proper LTP processes ensure remuneration policies are effective. LTP process must include contingent collateral calls and derivatives.

Topic 2. Best Practices for Governing the LTP Process

• Clear Policies and Centralization

  • Establish a well-defined LTP process with clear principles and rules for all business units.

  • A group treasury should centrally manage all wholesale funding.

  • Centralized funding prevents internal arbitrage and ensures proper oversight.

• Oversight and Control

  • Senior management and independent risk and financial control personnel must oversee the LTP process.

  • Regular meetings (monthly, not quarterly) should be held to monitor all funding costs.

  • Strong internal controls are more important than external factors in achieving LTP goals.

• Granular Reporting and Incentives

  • The LMIS should be able to attribute funding costs at a granular level, reflecting all costs, benefits, and risks for each business activity.

  • Employee compensation and bonuses should incorporate the cost of liquidity into the profitability of business units.

Topic 3. Challenges of Implementing the LTP Process

• Oversight and Governance

  • A major challenge is maintaining proper oversight to manage and monitor the process effectively.

  • Weak oversight can lead to the mispricing of liquidity premiums and the accumulation of illiquid long-term assets funded with short-term liabilities.

  • Centralized treasury centers are recommended to overcome challenges from decentralized funding structures.

• Trading Book Policies

  • Developing and implementing best practices for the trading book is a challenge.

  • LTP processes must properly account for potential liquidity costs from derivatives and contingent collateral calls.

• IT Infrastructure and Compensation

  • Ensuring the LMIS infrastructure is sufficient to produce timely and high-quality liquidity reports is a key challenge.

  • A further challenge is linking remuneration policies for executives to the LTP process to ensure they properly account for liquidity costs and risks.

Practice Questions: Q2

Q2. Which of the following best describes one of the major challenges for banks in implementing an effective LTP process?

A. A decentralized LTP process is recommended to mitigate arbitrage opportunities for different business units.

B. Illiquid long-term assets should be penalized for increasing liquidity risk.

C. Performance evaluations of business unit managers should be separate from the LTP process.

D. A liquidity management information system (LMIS) should produce and monitor high-quality reports on a quarterly basis.

Practice Questions: Q2 Answer

Explanation: B is correct.

A major challenge in implementing an effective LTP process is properly accounting for the cost of liquidity in funding illiquid long-term assets and crediting business units that create benefits of liquidity through deposits. Liquidity costs, benefits, and risks should be considered in rewarding manager performance. The LMIS should create monthly reports not quarterly reports. Centralized treasury funding oversight is recommended to reduce business unit arbitrage opportunities.

Module 2. Approaches For Liquidity Transfer Pricing And Contingent Liquidity Risk Pricing

Topic 1. Approaches to Liquidity Transfer Pricing

Topic 2. Zero-Cost Approach

Topic 3. Pooled Average Cost of Funds Approach

Topic 4. Separate Average Costs of Funds Approach

Topic 5. Marginal Cost of Funds Approach

Topic 6. Applying the Matched-Maturity Marginal Cost Approach in Practice

Topic 7. Contingent Liquidity Risk Pricing Process

Topic 1. Approaches to Liquidity Transfer Pricing (LTP)

• A 2009 survey of 38 banks across nine countries identified four primary approaches to LTP: zero cost, pooled average cost, separate average cost, and matched-maturity marginal cost.

• While all these approaches used the swap curve as a reference for pricing interest rate risk, they varied significantly in how they added liquidity premiums.

• The best practice for LTP is the matched-maturity marginal cost of funds approach.

Topic 2. Zero-Cost Approach

• In this approach, liquidity was treated as a free good, with no costs, benefits, or risks assigned to it.

• No charges were applied to assets for using funding liquidity, and no credits were given to liabilities for providing it.

• The rate charged to users of funds was simply derived from the swap curve, with no additional spread for liquidity.

• This approach led banks to accumulate balance sheets with a heavy overweighting of illiquid assets and few long-term liabilities to offset funding demands.

• The swap curve represented both the cost of funding for assets and the credit for providing funding for liabilities, with zero premium or spread added for liquidity.

Topic 3. Pooled Average Cost of Funds Approach

• This method averages the interest expense of funds across all maturities to charge users of liquidity and credit providers of liquidity.

• Assets are assigned a fixed spread (an average cost of funding) above the swap rate across all maturities.

• Similarly, the same average spread is used for liabilities, creating a "benefit of funds" curve below the swap curve.

• Disadvantages:

  • It charges all assets the same amount for liquidity risk, regardless of their maturity, which undercharges longer-term, higher-risk assets.

  • Providers of liquidity receive the same credit regardless of the maturity of their deposits, failing to incentivize longer-term funding.

Topic 4. Separate Average Costs of Funds Approach

• To address some issues of the pooled approach, some banks used a separate average cost for assets and liabilities.

• This approach applies different average spreads for assets and liabilities across all maturities. For example, a bank might use a 9 bps spread for all loans and a 3 bps spread for all deposits.

• Advantage: Management can adjust the charge on assets to incentivize loan activity without affecting the liability side of the balance sheet.

• Disadvantages:

  • Like the pooled approach, it still applies an average spread regardless of maturity, distorting profit assessments and not reflecting current market liquidity risk.

  • This approach provides incentives to underwrite more long-term loans without encouraging long-term deposits to match them, increasing maturity mismatch and liquidity risk.

Topic 5. Marginal Cost of Funds Approach

• The best practice for LTP is the matched-maturity marginal cost of funds approach.

• This method uses the bank's actual market cost of funding to determine the appropriate liquidity spread.

• The spread is known as a  term liquidity premium, which is used to charge assets and credit liabilities.

• The marginal cost of funds curve is higher than the average cost of funds curve for long-term assets, reflecting a higher liquidity premium for greater liquidity risk.

• For shorter-term assets, the marginal cost curve is lower than the average cost curve, reflecting a smaller term liquidity premium.

• This approach correctly bases pricing on market rates across different maturities, using the swap curve as a reference.

Topic 6. Applying the Matched-Maturity Marginal Cost Approach in Practice

• A bank with fixed-rate borrowing costs from issuing unsecured wholesale term debt can assign the liquidity portion by converting those costs to floating rates through internal swap transactions between business units.

• The swap curve is used as the reference for these transactions.

• This approach ensures that the liquidity premium reflects the maturity of the product, providing a more accurate cost and benefit allocation than average cost approaches.

Practice Questions: Q1

Q1. Which of the following statements describes the best approach for liquidity transfer pricing?

A. Zero cost of funds approach is preferred in cases in which swap rates are unknown and undeterminable.

B. The pooled average cost of funds approach is more appropriate for banks with numerous business units.

C. The separate average cost of funds approach is preferred to accurately account for business units with large trading activities.

D. The matched-maturity marginal approach is preferred because it quantifies liquidity risk premiums across all maturities.

Practice Questions: Q1 Answer

Explanation: D is correct.

The best practice for LTP is the matched-maturity marginal cost of funds approach. This approach uses the bank’s actual market cost of funding to calculate the correct portion to liquidity.

Topic 7. Contingent Liquidity Risk Pricing Process

• Contingent liquidity risks, such as potential cash outflows from derivatives and collateral calls, should be included in the LTP process.

• Trading business units, for instance, are charged for the use of funds for these contingent commitments.

• Prior to the global financial crisis, the liquidity cost of potential margin calls was often not priced at all.

• A key challenge in implementing LTP is developing trading book policies that properly account for these contingent liquidity costs.

Practice Questions: Q2

Q2. A bank supplies a line of credit of $10 million that currently has $6 million already drawn. The bank determines that there is a 65 % probability the customer will use the remaining line of credit. The bank's cost of funding for the liquidity cushion is 16 bps . If the bank charges contingent commitments based on the probability of a drawdown, what should the charge for liquidity be for this line of credit?

A. $1,664.

B. $2,496.

C. $4,160.

D. $5,850.

Practice Questions: Q2 Answer

Explanation: C is correct.

The rate charged for the contingent commitment is determined as follows:

Multiplying this cost times the $10 million credit line amount yields a dollar cost
of $4,160.