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Answer: An average cost of funds approach tends to result in the greatest maturity transformation for a bank's balance sheet.
## Analysis of Liquidity Transfer Pricing Approaches ### Understanding the Different Approaches: **A. Zero-cost of funds approach:** - This approach assigns zero cost to stable deposits - It encourages business units to use stable deposits to fund long-term assets - However, it doesn't specifically lead to long-term illiquid assets funded by long-term stable liabilities **B. Average cost of funds approach:** - This approach uses the bank's overall average funding cost - It creates incentives for business units to fund long-term assets with short-term liabilities - This results in significant **maturity transformation** (borrowing short and lending long) - **This statement is correct** - average cost approach tends to result in the greatest maturity transformation **C. Matched-maturity marginal cost approach:** - This approach assigns funding costs based on the specific maturity of each asset - It doesn't convert fixed-rate borrowing to floating-rate borrowing - This statement is incorrect **D. Average cost and zero-cost approaches:** - Neither of these approaches properly aligns maturities - They actually create misalignment incentives - This statement is incorrect ### Key Insight: The **average cost of funds approach** creates the strongest incentive for maturity transformation because business units can fund long-term assets at the bank's average cost, which includes cheaper short-term funding. This encourages them to maximize the spread between long-term asset yields and the average funding cost, leading to significant maturity mismatches.
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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 liquidity transfer pricing approaches and to prepare a report with recommendations. Which of the following statements should be included 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.