Outline how a fractional reserve bank runs asset-liability management, including how it carries out liquidity transformation.
The idea
A fractional reserve bank funds long-term, illiquid assets such as loans with short-term, liquid liabilities such as demand deposits, keeping only a fraction of deposits as reserves of cash and central bank balances. This is liquidity transformation, together with maturity transformation. It gives savers liquid claims and borrowers credit, but it exposes the bank to withdrawals larger than its liquid assets. Asset-liability management therefore lays out expected cash inflows and outflows in a maturity ladder, and computes the gap in each bucket and cumulatively. It also holds a buffer of high-quality liquid assets and diversifies funding. Funds transfer pricing charges business lines for term funding, and stress tests check the run-off assumptions. Deposit insurance and the central bank as lender of last resort are the backstops. The common error is valuing illiquid assets at face value when in a run they sell at a discount.
A practice question
In a fractional reserve bank, what is meant by liquidity transformation?
- Packaging loans into securities and selling them to investors, so that the bank retains no credit exposure to the underlying borrowersWhy not: Confuses liquidity transformation with securitisation, which transfers credit risk.
- Funding illiquid long-term loans with liquid demand deposits while holding only a fraction of deposits as reserves - correct
- Matching the maturity of each asset to a liability of identical maturity so that no liquidity gap existsWhy not: Describes a matched book, the opposite of what a fractional reserve bank does.
- Converting deposits received in foreign currency into domestic currency loans of equal sizeWhy not: Describes currency conversion, which has nothing to do with the liquidity of assets versus liabilities.
Liquidity transformation is the creation of liquid claims (deposits) backed by illiquid assets (loans); the gap between the two is what ALM must manage.
A harder one
How does funds transfer pricing support a bank's asset-liability management?
- It sets the rate at which the central bank lends reserves to the bank in an emergency.Why not: Confuses an internal allocation mechanism with the central bank's lending rate.
- It removes the need for a liquidity buffer because each unit is made to fund itself, so no pool of liquid assets is held centrally.Why not: Overstates what internal pricing does; it allocates costs but does not create liquid assets to meet outflows.
- It allocates expected credit losses on loans to the business units that originated them, and so prices credit rather than liquidity.Why not: Describes credit loss allocation, not the pricing of funding term and liquidity.
- It charges business lines an internal rate for the term funding they use and credits stable funding raised, so liquidity cost shapes pricing. - correct
Funds transfer pricing internalises the cost of liquidity: long, illiquid lending is charged a term funding rate and stable deposits earn a credit, aligning incentives with the bank's liquidity position.
The hardest tier
A bank has deposits of USD 1,000 million, of which 60% are stable retail deposits assumed to run off by 5% in a 30-day stress and 40% are wholesale deposits assumed to run off by 40%. It holds central bank reserves of USD 50 million, government bonds of USD 150 million (haircut 0%) and corporate bonds of USD 100 million market value (haircut 20% in stress). Ignoring inflows, what is the 30-day surplus of liquid buffer over outflows, closest to?
- USD 110 millionWhy not: Counts the corporate bonds at full market value, ignoring the stress haircut.
- USD 90 million - correct
- USD 20 millionWhy not: Applies the 40% run-off to the stable deposits and 5% to the wholesale deposits, reversing the assumptions.
- USD 10 millionWhy not: Leaves the corporate bonds out of the buffer entirely rather than counting them after the haircut.
Outflows = 0.05 x 600 + 0.40 x 400 = 30 + 160 = 190. Buffer = 50 + 150 + 0.8 x 100 = 280. Surplus = 280 - 190 = 90. Stress run-off differs by funding type and assets are counted after haircuts.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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