Measuring and Managing Liquidity Risk

11

Cost of liquidity and fund transfer pricing

11.1 INTRODUCTION

In Chapter 7 we presented an approach to derive the term structure of available funding (TSFu) given the funding sources and liquidity buffer needed to cope with gap risk on rollover dates. In this chapter we design a consistent framework to build the funding (interest rate) curve of a bank, as a mix of the costs of different funding sources entering the TSFu, and we indicate a methodology on how to properly include risks related to refunding activity in the cost of funds transferred from the treasury department to business units to buy assets.

To this end, we first introduce a brief overview of fund transfer pricing (FTP) principles, then we sketch a stylized bank's balance sheet, so that in a single-period setting we can clearly disentangle the several cost and risk components entering the fair pricing of assets, such as loans. We show the single building blocks that make up the price of an asset, including market, credit and liquidity costs (along the lines sketched in Chapter 10). We focus on a theoretical framework to quantify funding costs and gauge funding risk. Finally, we show how to apply the framework in practice.

11.2 PRINCIPLES OF TRANSFER PRICING

When a bank wants to invest in a given asset, it has to calculate its value. We showed in Chapter 10 a general approach to identify funding costs as well as the profit the bank can expect to make (on a risk-adjusted basis). We now expand the analysis by considering ...