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

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

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

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 deskThe 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

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

INTRODUCTION

For ALM purposes, the major units are: the lending units the deposit taking units the trading unit the ALM desk

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

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

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


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


The ALM desk takes the excess funds from the retail unit and lends them outIt may lend them to another bank in the interbank market or to another group within the bank, such as commercial lending or the trading groupIn return for providing these funds, the retail group receives some interest payments from the ALM deskIn 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


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.


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.


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.


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.


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.

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.


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.

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


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.


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.


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


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 amountThis is illustrated in Figure 15-4, in which the business units interact with the ALM desk as if it were the interbank market


>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.

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



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


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.

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)


4th rule The trading unit is a special case Like the other units, any transaction between the tradi

ng 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.

Risk Allocation

Documents

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