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Summary of CEBS Guidelines on Liquidity Cost Benefit Allocation (CP36)

Core Content

The CEBS Consultation Paper CP36 outlines guidelines for the allocation of liquidity costs, benefits, and risks within financial institutions. These guidelines aim to support effective liquidity management by ensuring that internal pricing mechanisms reflect the true cost of liquidity and align with the institution's risk appetite and strategic direction. The document emphasizes the importance of internal governance, transparency, and the use of appropriate methodologies for calculating internal funding prices.

Main Objectives

• To provide high-level guidance on creating or reviewing liquidity cost benefit allocation mechanisms.
• To ensure that these mechanisms incorporate all relevant liquidity costs, benefits, and risks.
• To promote a risk-aware culture and align business lines' risk-taking incentives with liquidity exposures.
• To support strategic decision-making by linking liquidity resource allocation with the institution's business model and risk tolerance.

Key Elements of the Guidelines

1. Liquidity Cost Components

• Direct costs: Include the market cost of raising funds and the interest rate curve cost component.
• Indirect costs: Include mismatch liquidity costs, contingent liquidity risk costs (e.g., liquidity buffer, roll-over risk), and other liquidity risk exposures (e.g., country risk costs for non-fungible currency balance sheets).
• Marginal vs. average marginal costs: The mechanism should distinguish between the direct cost of the last funding transaction and the weighted average of marginal costs across funding sources.

2. Governance and Implementation

• The liquidity cost benefit allocation mechanism must be approved by the management body or a delegated governing body (e.g., ALCO).
• It should be transparent, consistent, and regularly updated.
• The responsible function for internal pricing should be service-oriented, not profit-driven, and have appropriate technical systems and databases.
• The mechanism should be integrated across the institution, including subsidiaries, to ensure consistent application and visibility.

3. Usage of Internal Prices

• Internal prices should be used for:
  • Liquidity pricing
  • Performance measurement
  • Appraisal of new products or businesses
• These prices should be at an appropriate level of granularity and reflect both direct and indirect funding costs, including liquidity buffer costs.
• The mechanism should be adaptive to changing market conditions and updated regularly.

4. Behavioral Models and Pricing Curves

• Behavioral models should be validated and reviewed regularly, especially when there are material changes in business strategy.
• Internal pricing funding cost curves should be based on:
  • Risk-free rates
  • Liquidity premiums (maturity-specific and institution-specific)
  • Country risk premia
  • Specific retail network fees
• These curves are often derived from market benchmarks like Euribor/Libor or swap curves, adjusted for unique institutional or product attributes.

5. Special Considerations

• Sight deposits: Should be properly treated as part of the liquidity cost structure. Retail deposits are generally considered more stable than wholesale ones.
• Trading book assets: Should be priced with consideration to their expected holding period, market liquidity risk, and hedging requirements.
• Committed vs. uncommitted credit lines: Committed lines require pricing based on the expected maturity, while uncommitted lines should be priced similarly to reflect implicit support.
• Contingency liquidity costs: These should be calculated and allocated to business units responsible for generating the risk, using methods outlined in Annex 2.

Annexes Overview

Annex 1: Liquidity Cost Allocation - Examples

• Five European institutions were surveyed, all of which had internal pricing methodologies.
• Approvals for pricing policies varied between the Board, CFO, and ALCO.
• The Treasury division is typically responsible for implementation, with some institutions using Group ALM.
• Most institutions considered Treasury as a cost center.
• Some systems allowed for amendments to internal prices to incentivize certain behaviors, while others were rigid.
• The scope of application included assets, deposits, and all assets and liabilities.
• Pricing mechanisms varied, with some including risk-free curves, CDS spreads, liquidity premiums, and buffer costs.
• Frequency of price updates ranged from daily to monthly.

Annex 2: Calculating Contingency Liquidity Costs

• The liquidity buffer is used as a basis for calculating contingency liquidity costs.
• The cost includes:
  • Funding cost of the buffer
  • Opportunity cost of holding lower yielding highly liquid assets
• The cost is attributed to funding with the corresponding maturity (up to one month in this example).
• The metric is dynamic and forward-looking, reflecting both current and expected liquidity needs.

Conclusion

CEBS aims to ensure that liquidity cost benefit allocation mechanisms are comprehensive, transparent, and aligned with the institution's risk appetite and strategic objectives. These mechanisms are essential for promoting efficient liquidity management and supporting sustainable business models. The guidelines are expected to be implemented by 30 March 2011, with a public consultation period ending on 10 June 2010.