Liquidity Transfer Pricing

Liquidity transfer pricing is the method a bank uses to charge its business lines for the liquidity they consume and to credit those that supply it. A unit that makes long-term loans is charged for the cost of funding them for that term and for any liquidity buffer they require; a unit that gathers stable deposits is credited for the funding value it brings. The aim is to make product pricing, profit measurement and incentives reflect the true cost of liquidity and the risks it carries.

Liquidity transfer pricing is a component of the broader funds transfer pricing framework, which also covers interest rate risk. It is managed by a bank's central treasury and is closely linked to liquidity risk management and regulatory metrics such as the liquidity coverage ratio and the net stable funding ratio.

Think of a household where one person earns a steady salary and another runs a hobby business that needs money tied up in stock for months. If nobody counts the cost of that tied-up money, the business looks more profitable than it really is, and the family may run short of cash when a bill arrives.

Inside a bank, the treasury acts as the household's accountant. It charges the lending teams for the money and safety cushion their loans require and pays the deposit teams for the steady funding they bring in, so that each team's results show what it really costs or contributes.

• Term liquidity premium. The extra cost of borrowing for longer periods, usually measured as the spread of the bank's own unsecured funding curve over a benchmark such as the swap curve.
• Contingent liquidity cost. The cost of holding a liquidity buffer of high-quality assets against possible outflows, such as drawdowns of credit lines or deposit withdrawals.
• Liquidity credits. Payments to business lines for funding they provide, which are higher for stable retail deposits than for volatile wholesale deposits.

A simple transfer rate for an asset combines a base rate with liquidity components:

• $\text{Base rate}$ is the interest rate for the same term without credit or liquidity spreads, often a swap rate.
• $\text{Term liquidity premium}$ reflects the bank's cost of locking in funding for that term.
• $\text{Contingent liquidity charge}$ covers the cost of the buffer linked to the product.

Suppose a bank makes a five-year business loan. The five-year swap rate is 3.50 per cent, the bank's five-year term liquidity premium is 0.60 per cent, and the cost of the buffer associated with the customer's undrawn credit line is 0.10 per cent. The transfer rate is 3.50 + 0.60 + 0.10 = 4.20 per cent. If the loan is priced at 5.50 per cent, the lending unit's margin before credit and operating costs is 5.50 − 4.20 = 1.30 per cent. Without the liquidity components, the unit would appear to earn 2.00 per cent and might be encouraged to lend more than the bank can safely fund.

Before 2007, many banks charged little or nothing for liquidity, which encouraged them to fund long-dated, hard-to-sell assets with short-term borrowing. When funding markets froze during the financial crisis, those hidden costs became losses. In September 2008 the Basel Committee on Banking Supervision published its Principles for Sound Liquidity Risk Management and Supervision, which require banks to include liquidity costs, benefits and risks in internal pricing, performance measurement and new product approval. In Europe, the Committee of European Banking Supervisors issued guidelines on liquidity cost and benefit allocation in 2010, and supervisors now review transfer pricing as part of their assessment of liquidity risk.

Setting liquidity charges requires judgement. Behavioural assumptions, such as how long non-maturity deposits will stay or how much of a credit line will be drawn, drive the results, and different assumptions can change product profitability sharply. Charges based only on current market spreads can swing widely, so banks often smooth them, which may delay signals. Business lines may dispute charges that reduce their reported profits. Poorly designed frameworks can also miss the link between deposit stability and liquidity risk, crediting rate-sensitive deposits as if they were as sticky as small retail balances. Good practice keeps the methodology documented, independent of the business lines, and consistent with the bank's stress testing, so that the charges track the real economics of its deposit franchise and its banking book.

• Basel Committee: Principles for Sound Liquidity Risk Management and Supervision