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Treasury Consulting > Transfer pricing liquidity risk

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Published: 16th January 2010 by William Webster

Transfer pricing liquidity risk - don’t write business at the wrong price

A trader will tell you that there is a simple rule to pricing. The starting point is the cost of hedging. What does that mean? If you make a fixed rate loan and use a swap to hedge, this becomes the starting point for the loan price. A spread is then added for credit risk.

But in order to make a loan most banks borrow short term. This increases profitability but also adds liquidity risk.

A bank that fails to take this into account will under price the loan. That's a mistake because you are taking risk without receiving recompense. Before the crisis banks could more-or-less ignore this. That's because the risk and cost of liquidity was perceived as being very low. Regulatory changes have altered this.

Banks are now required to improve their liquidity. The focus has been on increasing the quantity and quality of the liquidity buffer, reducing reliance on wholesale funding, strengthening reporting and improving governance.

Stress testing now affects the quantity of liquidity held by banks. It looks at what could happen in relatively extreme conditions, the parameters are largely prescriptive. One outcome of stress testing is that liquidity buffers will increase. This won't be instantaneous it will occur over a number of years.

What's held in the liquidity buffer will also change. In practice it will be high quality low yielding assets, typically government debt. Banks will incur a real cost for this increase in quality and quantity. How much is that?

Take a five year loan financed with a three month deposit. How large is the buffer that you need to hold and what is its cost of carry (interest income less expense). For every firm this will be different but a very simple exercise shows the following.

 

Loan              10,000,000.00

Carry cost      1.00%

 

Buffer  ratio    Buffer amount        Additional margin pa

10%                1,000,000                        0.10%

15%                1,500,000                        0.15%

20%                2,000,000                        0.20%

25%                2,500,000                        0.25%

 

For a firm where the buffer ratio is 20% (of the asset) and the carry cost is 1% an additional 25 basis points cost is incurred. What are the implications?

1. Failing to accurately transfer price the liquidity cost will inflate the profit of corporate lending at the expense of treasury

Any treasurer will tell you that running a liquidity book full of gilts just costs money. If that cost is attributed to treasury it is misallocated. It needs to be appropriated to where the risk is incurred and in this case it's corporate lending. If you don’t do this you encourage loan officers to market facilities too cheaply and treasuries to find ways of filling the hole, (that normally means taking risk). Could this happen to you?

2. Mitigating action that reduces the cost of the buffer potentially improves competitiveness

Of course there are several ways to do this. You could relax the stress testing or look for higher yielding buffer assets. But to do this would put you at risk of regulatory sanction so it's not advised. However more effective management action in times of liquidity stress should mean the buffer is smaller. How effective does the regulator consider you to be?

3. Look at the balance sheet

Wholesale funding, (particularly short term), internet deposits, deposits above insurance schemes, rate sensitive accounts, undrawn mortgage, credit card and loan facilities all create their own marginal liquidity cost. This needs to be reflected in pricing. If you don’t know what it is you will write business at the wrong price and have a long term balance sheet that underperforms. Is it time you had a long and hard look at this?  

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