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CEBS Recommendation 2 Analysis Summary

Core Content

The document provides a response to Recommendation 2 of the CEBS's Technical Advice on Liquidity Risk Management, issued on 17th June 2008. The original recommendation suggests that institutions should implement an internal cost/benefit allocation mechanism, supported by a transfer pricing mechanism, to incentivize appropriate liquidity risk behaviors and allocate all liquidity costs.

Main Views and Key Points

• Confusion in Wording: The original recommendation is seen as potentially confusing because it conflates two distinct mechanisms—cost/benefit allocation and transfer pricing—which serve different purposes and may not be complementary.

• Proposed Changes: The authors suggest that the recommendation should be split into two separate parts or paragraphs to clarify its objectives:

  • A transfer pricing mechanism should be established to provide incentives for liquidity generation and use, aligned with the institution’s risk appetite.
  • An internal cost/benefit allocation mechanism should be created to adjust the costs from the transfer pricing mechanism to reflect all liquidity costs, including short- and long-term, and contingent risk.

• Justification for Splitting:

  • Cost Allocation is a strategic objective, aimed at evaluating business performance.
  • Transfer Pricing is a tactical mechanism, designed to influence business decisions by incorporating liquidity implications.
  • These two mechanisms often conflict in objectives and cannot be effectively combined in a single system.

Key Information

Yield Curve Framework

• The yield curve approach uses market rates for different tenors (e.g., overnight, week, month) and interpolates rates where data is missing.
• This method provides clear incentives to manage liquidity risk but fails to accurately reflect total liquidity costs.

Two-Way Pricing

• Two-way pricing is necessary to regulate liquidity generation by adjusting the internal bid-offer spread.
• It allows for incentivizing or discouraging liquidity behaviors, but it distorts the accuracy of cost allocation due to internal profit creation and the lack of reflection of true liquidity costs in the offer price.

External vs. Internal Liquidity Pricing

• Banks operating in external inter-bank markets face challenges in creating a differential between external quoted prices and internal liquidity pricing due to arbitrage opportunities.
• Transfer pricing in such cases reflects marginal short-term funding costs, which are not representative of the total liquidity costs.

Conclusion

• Transfer Pricing Mechanism:
  • Most effective in encouraging desired liquidity behaviors.
  • Least effective in accurately allocating total liquidity costs.
• Single Rate Approach:
  • Accurately allocates funding costs but lacks transparency and fails to reflect current market rates.
  • Has several drawbacks:
    • Applies a single rate to all assets, regardless of maturity or quality.
    • Rewards liquidity generation and consumption equally, leading to potential excess liquidity during periods of falling interest rates.
    • Reflects a hindsight view, as it is determined with a delay.
    • Ignores the maturity profile of funding and liabilities.

Summary

The document highlights the need for clarity in CEBS Recommendation 2, emphasizing that transfer pricing and cost/benefit allocation serve different purposes and cannot be effectively combined. It argues that while transfer pricing mechanisms are crucial for influencing liquidity behavior, they do not accurately reflect total liquidity costs. Conversely, a single rate approach may be more accurate in cost allocation but fails to incentivize appropriate liquidity risk management. The authors conclude that achieving an accurate and effective liquidity cost allocation is complex, and the effectiveness of transfer pricing in behavior incentives comes at the cost of accuracy in cost reflection.