Liquidity Transfer Pricing and Limits

Robert Fiedler

In the previous chapters we have outlined how illiquidity risk can be quantified and which measures can be taken to counterpoise unwanted illiquidity risk. So far, however, we have not explained how the bank can distinguish and prioritise individual countermeasures, or how it can incentivise its departments to carry out certain “good” measures and minimise liquidity risks.

In this chapter we will describe how a bank can measure the costs of counterbalancing illiquidity risk consistently and how it can incentivise its businesses to separate equitable business from those with depleted return or excessive risks.

Generally speaking, a transfer price is the price at which goods (or services) are sold between divisions of a company, or between companies in the same group (if they have the same parent company). Going more into detail, we will first describe the basic transfer-pricing concepts banks apply. For our purposes we need a method which can be applied for each individual transaction (asset or liability): each originated asset (or liability) is assumed to be individually refinanced (or placed) by means of a so-called replication transaction. The profit of the originated