Liquidity Transfer Pricing

Joel Grant

As outlined in Principle 4 of the Basel Committee on Banking Supervision’s “principles for sound liquidity risk management and supervision” banks should incorporate liquidity costs, benefits and risks in the product pricing, performance measurement and new product approval process for all significant business activities (both on and off balance sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole (Basel Committee on Banking Supervision 2008, p. 9). This process is referred to as liquidity transfer pricing (LTP) and is the focus of this chapter.

LTP has attracted considerable attention since the liquidity events witnessed during the 2007–9 global financial crisis (GFC). Broadly speaking, bank LTP practices have improved, particularly in the area of the banking book, due to a combination of factors including a better understanding of the process, increased scrutiny by bank senior management and supervisors, and the introduction of new liquidity regulations. However, further work is needed in applying LTP to the trading book and inter-company transactions, and in using LTP