Liquidity transfer pricing: a guide to better practice

FSI Papers
December 2011

Executive summary

This paper identifies better practices for liquidity transfer pricing (LTP) by drawing on the responses to an international survey that covered 38 large banks from nine countries. The survey focused on the enhancements banks are making to their LTP processes.

Responses to the survey show that many LTP practices were largely deficient. Many banks lacked LTP policies, employed inconsistent LTP regimes, relied on off-line processes to manually update changes in funding costs, and had poor oversight of the LTP process. Probably the most striking example of poor practice was that some banks failed to attribute liquidity costs to assets and conversely liquidity credits to liabilities for some business activities. Others did attribute liquidity costs and benefits, albeit at one average rate. This approach failed to penalise longer-term funding commitments for assets and, conversely, reward longer-term funding benefits from liabilities, and failed to incorporate timely changes in banks' actual market cost of funds. Moreover, banks' liquidity cushions were too small to withstand prolonged market disruptions and were comprised of assets that were thought to be more liquid than they actually were. Overall, these shortcomings encouraged risky maturity transformation, without regard to the structural liquidity risk that was being generated.

Better LTP practice requires each bank to produce and follow an LTP policy that defines the purpose of LTP and provides principles and/or rules to ensure LTP achieves its intended purpose. Banks should manage LTP centrally, such as in group treasury, with sufficient oversight provided by independent risk and financial control personnel. Treasury should have complete visibility of individual business balance sheets. To properly manage funding liquidity risk, banks should charge rates based on their marginal cost of funds and matched to the maturity of the product or business activity at origination. For amortising or non-maturing products, blended marginal rates should be applied. In regard to the sizing of liquidity cushions, banks should use the results of stress-testing and scenario analyses, which include idiosyncratic and market-wide disruptions, as well as a combination of the two. Assets held as part of banks' liquidity cushions should be of the highest quality to ensure liquidity can be generated when needed. Finally, business activities creating the need for banks to carry additional liquidity should be charged based on their expected usage of contingent liquidity.

Overall, better LTP practices will ensure that banks accrue less illiquid and correlated assets, use more stable sources of funding to meet the demands of their business activities, and carry a more sufficiently sized liquidity cushion to withstand unexpected idiosyncratic and/or market-wide disruptions. Banks, supervisors and other stakeholders are therefore encouraged to consider the better LTP practices that are identified in this paper.