Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Pricing of liquidity

Prior to the crisis, liquidity risk was under priced and even ignored. Now, the pendulum has swung to the other extreme, but the result may once again be that liquidity is mispriced.

The Financial Stability Institute set up by the Bank for International Settlements and the Basel Committee on Banking Supervision has published a paper “Liquidity transfer pricing: a guide to better practice” by Joel Grant of the Australian Prudential Regulation Authority. The paper argues that a matched maturity transfer pricing method based on the swap yield curve does not price liquidity at all:

These banks came to view funding liquidity as essentially free, and funding liquidity risk as essentially zero. … If we assume that interest rate risk is properly accounted for using the swap curve, then a zero spread above the swap curve implies a zero charge for the cost of funding liquidity.

I find myself in total disagreement with this assertion. The standard liquidity preference theory of the term structure says that the long term interest rate is equal to the expected average short term interest rate plus a liquidity premium. So matched maturity transfer pricing does price liquidity. If you accept the market liquidity premium as correct, then one can go further and say that the swap based approach prices liquidity perfectly; but I do not wish to push the argument that far. I would only say that Grant’s argument would hold true only under the pure expectations theory of the term structure, and in this case, the entire market is, by definition, placing a zero price on liquidity.

The paper argues that matched maturity transfer pricing must be based on the bank’s borrowing yield curve – the bank’s fixed rate borrowing cost is converted into a floating rate cost (using an “internal swap”) and the spread of this floating rate borrowing cost over the swap yield curve is treated as a liquidity premium. I believe that the error in this prescription is that it conflates credit and liquidity risk. The spread above the swap curve reflects the term structure of the bank’s default risk. Grant seems to recognize this, but then he ignores the problem:

This … reflects both idiosyncratic credit risks and market access premiums and is considered to be a much better measure of the cost of liquidity.

I believe that there is a very big problem in including the bank’s default risk premium in pricing the assets that the bank is holding. The problem is that the bank’s default risk depends on the asset quality of the bank. Transfer pricing based on this yield curve can thus set up up a vicious circle that turns a healthy bank into a toxic bank. A high transfer price of funds means that the bank is priced out of the market for low risk assets and the bank ends up with higher risk assets. The higher risk profile of the bank increases its borrowing cost and therefore its transfer price. This pushes the bank into even more risky assets and the vicious circle continues until the bank fails or is bailed out.

This problem is well known even in corporate finance where a firm is engaged in many different lines of business. There the solution is to use a divisional cost of capital which ignores the risk of the company as a whole and focuses on the risk of the division in question. The use of a corporate cost of capital in diversified companies leads to the lower risk businesses being starved of funds while the high risk businesses are allowed to grow. Ultimately, the corporate cost of capital also rises. Divisional cost of capital solves this problem.

It would be very odd if a regulatory guide to best practice ignores all this learning and pushes banks in the wrong direction. We should not lose sight of the simple principle that assets must be priced based on the characteristics of the asset and not the characteristics of the owner of the asset.

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2 responses to “Pricing of liquidity

  1. Pingback: The Return of Risk? « theMarketSoul ©1999 – 2012

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