Recent trends in liquidity risk management: funds transfer pricing

In the wake of the financial crisis, one of the biggest failures observed in the financial system refers to the poor evaluation of the exposure to liquidity risk as well as to its pricing. The ideal funding environment preceding the turmoil (where liquidity was plentiful and cheap) led many banks to overlook liquidity and funding implications of deals, thereby encouraging an increase in leverage as well as an excessive maturity transformation to make record profits. In hindsight liquidity revealed itself as a scarce, expensive and strategic resource that requires to be effectively allocated and managed and its cost charged to different business units, products and counterparties accordingly. According to the extraordinarly changes registered in the financial landscape, marked by more and more competitive markets where funding is available only for shorter periods and at a higher price, liquidity pricing frameworks in banks became an essential tool to measure the risk-adjusted profitability at a more granular level while addressing the impact of liquidity risk and other ALM risks on a financial firms’ balance sheet structure, segregating them from operations. Failures to adequately apply liquidity transfer pricing processes, both on- and off- balance sheet, generated risks, due to the misalignment of the risk-taking incentives at individual level and consolidated one, leading to a wrong allocation of capital resource within the business units. However, the growing importance of liquidity pricing largely derives not only from market events. More recently, worldwide regulators have been increasingly focused on pricing liquidity. The regulatory initiatives will pose challenges for banks to overhaul their existing funds transfer pricing (FTP) frameworks and to incorporate formally liquidity risks. As a result banks, especially the largest, cross-border and more sophisticated ones, are revising and reshaping their approaches to meet regulatory expectations as well as to take into account the multi-dimensionality of liquidity risk as well as its interconnections with the organizational structure, the balance-sheet items, etc. This process is underway and still not completed. In such a perspective, after an introduction on the theoretical frameworks for FTP, the paper reviews some of the methodologies for pricing liquidity, implemented by cross-border banking institutions, pointing out their intrinsic weaknesses. In the light of empirical evidences that covers the period starting just before the crisis to nowadays, we analyze the evolution of the main different FTP components showing the most significant results from a macro and a micro-perspective as well. Some potential areas of improvements and challenges will be highlighted. Finally, we describe a few benefits achievable through the adoption of a FTP approach.