Contrast the zero-cost, average-cost and matched-maturity marginal-cost routes to setting internal liquidity transfer prices.
The idea
There are three broad routes to setting internal liquidity prices. Zero-cost means no liquidity charge or credit at all, so funds look free and units are encouraged to hold illiquid assets and neglect stable funding. Average-cost charges and credits every unit one pooled rate, equal to total funding cost divided by total funds, whatever the tenor. It is simple but cross-subsidises, because short-dated positions are over-charged and long-dated ones under-charged when long funding costs more. Matched-maturity marginal-cost prices each asset or liability at the current cost of raising funds of the same tenor, using the bank's own curve, so the rate reflects both maturity and today's market. Amortising positions are split into tranches, each priced at its own tenor. Treasury keeps the residual mismatch. The exam point is that matched-maturity marginal cost gives the most accurate signal and is regarded as best practice.
Formulas
Average-cost transfer rate
Pooled = Cost ÷ Funds
- Cost
- total interest and non-interest cost of all sources
- Funds
- total funds raised, net of reserves where they apply
One rate for every tenor. When long funding costs more, it over-charges short positions and under-charges long ones, so matched-maturity pricing gives the truer signal.
A practice question
What is the main advantage of matched-maturity marginal-cost pricing over the zero-cost and average-cost approaches?
- It is the simplest approach, needing only one rate and no maturity data.Why not: Describes the pooled or zero-cost simplicity; matched-maturity pricing needs maturity data and a curve.
- It prices each position at the current cost of funds of its own tenor, giving an accurate signal. - correct
- It guarantees that Treasury has a zero residual however the balance sheet is funded.Why not: Treasury still keeps the residual from mismatches between assets and liabilities.
- It ignores market conditions so rates stay stable through the cycle.Why not: Marginal-cost rates move with market conditions, which is the point of using them.
Matched-maturity marginal-cost pricing ties each rate to the tenor and to the current market cost of funds, so prices convey the true cost of liquidity. Its price is greater accuracy, not simplicity.
A harder one
A bank funds itself with USD 400 million of deposits at 1.5%, USD 300 million of one-year wholesale funds at 3.5% and USD 300 million of five-year debt at 5.0%. A 5-year loan earns 5.0%, and the current marginal cost of 5-year funds is 4.6%. By how much does the average-cost approach overstate the loan's margin relative to matched-maturity marginal-cost pricing?
- 1.27 percentage pointsWhy not: Uses the simple average of the three funding rates (3.33%) instead of the volume-weighted average of 3.15%.
- 0.40 percentage pointsWhy not: Reports the margin under matched-maturity pricing only, rather than the difference between the two approaches.
- 1.45 percentage points - correct
- 1.85 percentage pointsWhy not: Reports the average-cost margin only, rather than the difference between the two approaches.
Pooled rate = (400 x 1.5% + 300 x 3.5% + 300 x 5.0%) / 1,000 = 3.15%. Average-cost margin = 5.0% - 3.15% = 1.85%. Matched margin = 5.0% - 4.6% = 0.40%. Overstatement = 1.45 percentage points.
The hardest tier
A USD 120 million loan amortises in two equal instalments of USD 60 million at the end of years 1 and 2. Treasury's marginal funding costs are 2.0% for one year and 3.0% for two years. With each repayment tranche funded at its own tenor, what is the first-year liquidity charge?
- USD 3.6 millionWhy not: Prices the entire loan at the 2-year rate of 3.0%, treating it as a bullet loan.
- USD 2.4 millionWhy not: Prices the entire loan at the 1-year rate of 2.0%, ignoring the tranche that stays outstanding.
- USD 1.8 millionWhy not: Counts only the 2-year tranche and omits the charge on the 1-year tranche.
- USD 3.0 million - correct
Matched-maturity pricing splits the loan into tranches. Year-1 charge = 60 x 2.0% + 60 x 3.0% = 1.2 + 1.8 = USD 3.0 million. The 2-year tranche stays outstanding; the 1-year tranche is repaid after year 1.
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