CHAPTER 15 Funds-Transfer Pricing and the Management of ALM Risks

1. CHAPTER 15Funds-Transfer Pricing and the Management of ALM Risks What is in this Chapter?INTRODUCTION TRADITIONAL TRANSFE PRICING AND ITS PROBLEMS MATCHED-FUNDS-TRANSFER PRICING GENERAL RULES FOR MATCHED-FUNDS-TRANSFER PRICING Risk Allocation

2. INTRODUCTION • In the preceding chapters, we examined the ALM interest-rate and liquidity risk to the bank. • For example, we showed that if the bank has made long-term loans by using money from short-term savings accounts, the bank will suffer a loss if rates rise

3. INTRODUCTION • However, we did not specify whether that loss should be counted as a loss on the loans, a loss on the savings accounts, or a loss to the fixed-income trading desk • The assignment of this profit and loss is important • It determines the risk and profitability of each business unit • It determines the price that the bank should charge its customers

4. INTRODUCTION • The way we determine where the risk is located is by using transfer pricing • Transfer pricing is a framework of internal transactions and payments between business units

5. INTRODUCTION • For ALM purposes, the major units are: • the lending units • the deposit taking units • the trading unit • the ALM desk

6. INTRODUCTION • The transfer payments significantly affect the measured accounting profitability of each unit • By affecting the measured profitability, we affect the prices that each unit must charge to its customers, and we affect the bonuses of the staff

7. INTRODUCTION • If one unit is forced to pay a higher transfer price to another unit, the first unit's measured profitability will fall, their bonuses will be reduced, and senior management may decide to scale back the activities of the less-profitable unit. • In this chapter, we are concerned only with funds-transfer pricing

8. INTRODUCTION • Funds-transfer pricing can be viewed as the interest payments charged when one unit lends funds to another • It is the structure of funds-transfer pricing which moves interest-rate and liquidity risks between units

9. TRADITIONAL TRANSFE PRICING AND ITS PROBLEMS • A typical situation in a universal bank is that the retail banking group takes in deposits and lends them out to retail customers • The amount of deposits generally exceeds retail loans, so the excess is given to the bank's ALM desk

10. TRADITIONAL TRANSFE PRICING AND ITS PROBLEMS • The ALM desk takes the excess funds from the retail unit and lends them out • It may lend them to another bank in the interbank market or to another group within the bank, such as commercial lending or the trading group • In return for providing these funds, the retail group receives some interest payments from the ALM desk • In the traditional framework, the transfer rate for these interest payments is typically either the overnight interbank rate or the retail deposit rate, plus a small spread to cover operating expenses

11. TRADITIONAL TRANSFE PRICING AND ITS PROBLEMS • This traditional transfer-pricing framework has several negative consequences • First, within the retail banking group, there is no clear line between the profitability of retail loans and deposits.

12. TRADITIONAL TRANSFE PRICING AND ITS PROBLEMS • If the retail group as a whole is profitable, it is not clear whether the profit is driven by raising cheap funds from deposits or giving well-priced loans. • Consequently, it is not clear whether to expand either the deposit program, the loan program, or both.

13. TRADITIONAL TRANSFE PRICING AND ITS PROBLEMS • Second, the interest rate given to the retail group for their excess funds tends to be lower than the rate they would have received if they had been able to lend the funds directly into the interbank capital market.

14. TRADITIONAL TRANSFE PRICING AND ITS PROBLEMS • Third, traditional transfer pricing makes it difficult to monitor and control interest-rate risk because a change in. market rates may affect the profitability of all business units. • Even if the commercial lending department had done a good job in making well-priced, well-structured loans to creditworthy customers, the department may still suffer a loss if their funding costs suddenly rise.

15. TRADITIONAL TRANSFE PRICING AND ITS PROBLEMS • To avoid these problems, a transfer-pricing framework is needed that recognizes the-true value of the funds and concentrates the interest-rate risk into one unit: the ALM desk. • This can be achieved by matched-funds-transfer pricing.

16. INTRODUCTION TO MATCHED-FUNDS-TRANSFER PRICING • To introduce matched-funds-transfer pricing, let us start with an example using traditional transfer pricing, and then show how matched-funds-transfer pricing ca be introduced to bring clarity to the risk and profitability.

17. INTRODUCTION TO MATCHED-FUNDS-TRANSFER PRICING • Consider a traditional bank raising funds in the form of 3-month deposits (FD and lending 5-year, fixed-rate loans. If the bank pays 4% for the FDs and receives 11% for the loans, the nominal net interest margin (NIM) is 7%. • This is illustrated in Figure 15-1.

18. The 7% spread between the loans and deposits should cover • the administrative costs • the credit loss on the loan • and the interest-rate risks due to the mismatch • There are two problems with this situation: • it is not possible to attribute profitability separately to the loans and FDs • there is interest-rate risk because if rates rise to 8% in 3 months, the bank will find itself with a net interest margin reduced to only 3%, which would not be enough to cover expenses

19. INTRODUCTION TO MATCHED-FUNDS-TRANSFER PRICING In this arrangement, the bank has no interest-rate risk because the 3-month liabilities are matched with a 3-month asset, and the 5-year loans are matched with a 5-year liability Furthermore, we can clearly see the profitability of each product.

20. INTRODUCTION TO MATCHED-FUNDS-TRANSFER PRICING we can clearly see the profitability of each product Notice that the bank has lost 1 % of income to the capital markets, but in exchange, it has no interest-rate risk and therefore does not need to hold capital against ALM risks.

21. INTRODUCTION TO MATCHED-FUNDS-TRANSFER PRICING • In practice, it would be difficult and costly to implement a structure in which every individual deposit is lent separately into the market and every loan requires funds to be individually borrowed from the market

22. INTRODUCTION TO MATCHED-FUNDS-TRANSFER PRICING • The practical alternative is to set up an internal market that aggregates all the individual transactions, and only to use the external market to borrow or lend the net amount • This is illustrated in Figure 15-4, in which the business units interact with the ALM desk as if it were the interbank market

23. INTRODUCTION TO MATCHED-FUNDS-TRANSFER PRICING >The commercial lending department making a five-year, fixed-rate loan (11%) to a customer >The department would borrow at a fixed rate for five years (7%) from the ALM desk.

24. GENERAL RULES FOR MATCHED-FUNDS- TRANSFER PRICING • 1st Rule: • the funding requirements for all transactions are considered to go through the ALM desk • This process is illustrated in Figure 15-5 • Notice that the business units do not just go to the ALM desk for their net requirements. • Each business unit gives all of its deposits to the ALM desk to be invested at market rates, and goes to the ALM desk for all its funding requirements if it wishes to make loans

25. GENERAL RULES FOR MATCHED-FUNDS- TRANSFER PRICING

26. GENERAL RULES FOR MATCHED-FUNDS- TRANSFER PRICING • 2nd Rule: • For every transaction, there is an agreement between the business unit and the ALM desk about the terms of the fictitious asset or liability • These terms are the same as would be agreed between the bank and an external counterparty

27. GENERAL RULES FOR MATCHED-FUNDS- TRANSFER PRICING • The terms specify the amount, the repricing frequency, the time for final repayment of the principle, any amortization, any prepayment options, and the rate, which is the current market rate • These terms should mirror the interest-rate characteristics of the business unit's transaction with the customer.

28. GENERAL RULES FOR MATCHED-FUNDS-TRANSFER PRICING • 3rd rule: • For each transaction, the business unit receives a fictitious asset (liability) and the ALM desk receives the opposite fictitious liability (asset)

29. GENERAL RULES FOR MATCHED-FUNDS- TRANSFER PRICING • 4th rule • The trading unit is a special case • Like the other units, any transaction between the trading unit and the ALM desk has the price fixed according to the effective maturity of the loan • However, unlike the other business units, the trading unit has access directly to the interbank market and is not required go to the ALM desk to match every transaction • For risk-measurement purposes, any fictitious liability that the trading unit has goes into the trading VaR calculator, and the corresponding fictitious asset goes into the ALM simulation.

30. Risk Allocation