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Examine the difficulties banks can face when putting LTP into practice.

FRM® Part II · Liquidity and Treasury Risk Measurement and Management · Liquidity Transfer Pricing: A Guide to Better Practice · FRM2.LTR.14.b

The idea

Putting LTP into practice is harder than designing it. Contractual maturities say little about non-maturity deposits, revolving lines and prepayable loans, so behavioural models are needed, and they are uncertain. Reference curves must be built per currency and tenor. Yet term funding spreads are thin, volatile or unobservable in a crisis, exactly when they matter most. Data and systems must capture every product and off-balance-sheet item. Rates must be refreshed often enough that quotes do not go stale. Internal prices that differ from the market create arbitrage and gaming, because business lines will grow whatever is over-credited and shun whatever is over-charged. Business resistance and the need for governance and senior sponsorship add to the burden. A common error is assuming the difficulty is purely technical. The exam point is that behavioural modelling, curve construction in stress, stale rates and incentive distortion are the standard difficulties.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following is a recognised practical difficulty in implementing LTP?

  1. Contractual maturities are unavailable for fixed-term loans and term deposits.Why not: Contractual maturities of fixed-term products are readily known; the difficulty lies with items lacking them.
  2. Supervisors prohibit banks from charging internal prices to business lines.Why not: No such prohibition exists; supervisors expect sound internal pricing of liquidity.
  3. Modelling the behavioural maturity of items such as non-maturity deposits and revolving credit lines. - correct
  4. Liquidity premia are identical across tenors, so the curve carries no information.Why not: Premia differ by tenor; the problem is constructing and maintaining the curve, not that it is uninformative.

Items without a contractual maturity, such as current accounts, credit card balances and revolving lines, need behavioural models, which are uncertain. That is a core implementation challenge, together with curve construction and data.

A harder one

A bank applies a single USD liquidity curve to transfer-price assets in every currency, although it funds euro assets through FX swaps that carry a basis cost. What is the main problem?

  1. The euro units are over-charged because USD premia are always higher than those in any other currency.Why not: Assumes USD premia always exceed others; the actual issue is that the curve ignores currency-specific cost.
  2. Euro business is under-charged for the swap-based funding it uses, creating cross-subsidies and hiding a funding gap. - correct
  3. There is no problem, since liquidity premia are independent of the currency of the asset funded.Why not: Premia and funding access differ by currency; funding in a different currency adds a basis cost.
  4. The units cannot book euro assets at all, because the USD curve has no euro tenors.Why not: A single curve can be applied mechanically; the failure is mis-pricing, not an inability to book assets.

Liquidity cost depends on currency, as FX-swap funding adds a basis cost. Using one USD curve under-charges the units that rely on swapped funding, so other units subsidise them. Curves should be built by currency.

The hardest tier

A bank has USD 500 million of non-maturity deposits. Behavioural analysis finds 70% is stable core with an effective term of five years and 30% is volatile and effectively overnight. Liquidity premia are 1.20% for five years and 0.10% for overnight. What annual liquidity credit should the deposit unit receive?

  1. USD 6.00 millionWhy not: Treats the whole balance as five-year funding, ignoring the volatile overnight part.
  2. USD 4.35 million - correct
  3. USD 0.50 millionWhy not: Treats the whole balance as overnight funding, as the contractual terms suggest.
  4. USD 2.15 millionWhy not: Swaps the weights, applying 30% to the five-year premium and 70% to the overnight premium.

Weighted premium = 0.70 x 1.20% + 0.30 x 0.10% = 0.87%. Credit = 0.87% x USD 500 million = USD 4.35 million. Splitting the balance by behavioural maturity is the difficult but necessary step.

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