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Answer: A matched-maturity marginal cost of funds approach converts the bank's fixed-rate borrowing cost to a floating-rate borrowing cost.
**Correct Answer: C** **Explanation:** - **Option C is correct** because a matched-maturity marginal cost of funds liquidity pricing policy converts the bank's fixed-rate borrowing cost to a floating-rate borrowing cost and equals the spread above a reference rate. - **Option A is incorrect** because a zero-cost liquidity pricing policy will tend to result in the bank holding long-term highly illiquid assets matched by short-term liabilities, not long-term stable liabilities. - **Option B is incorrect** because a zero-cost of funds liquidity pricing policy (not an average cost approach) will tend to result in the greatest maturity transformation for a bank's balance sheet. - **Option D is incorrect** because neither a zero-cost of funds approach nor an average cost of funds approach will appropriately align the maturity of the bank's lending and borrowing activities when remuneration is based on net income. A significant maturity mismatch between assets and liabilities can be structured by management to increase net income. **Learning Objective:** Compare the various approaches to liquidity transfer pricing (zero cost, average cost, and matched maturity marginal cost). **Reference:** Joel Grant, 2011. "Liquidity Transfer Pricing: A Guide to Better Practice," Occasional Paper, Financial Stability Board, Bank for International Settlements.
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A treasurer of a bank is assessing the different methods of pricing liquidity and is concerned about the potential impact of applying each method. The treasurer asks an analyst to review and evaluate the various approaches to liquidity transfer pricing and to prepare a report with recommendations. Which of the following statements would be correct for the analyst to include in the report?
A
A zero-cost of funds approach tends to result in the bank holding long-term highly illiquid assets funded by long-term stable liabilities.
B
An average cost of funds approach tends to result in the greatest maturity transformation for a bank's balance sheet.
C
A matched-maturity marginal cost of funds approach converts the bank's fixed-rate borrowing cost to a floating-rate borrowing cost.
D
Both an average cost of funds approach and a zero-cost of funds approach appropriately align the maturity of the bank's lending and borrowing activities when management compensation is based on net income.
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