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

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

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 cha

rge 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

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

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

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.


The commercial lending department making a five-year, fixed-rate loan to a

customer The department would borrow at a fixed

rate for five years from the ALM desk

The rate quoted to the department for that internal loan would be the rate that it would cost the ALM desk to borrow the money in the interbank market for five years at a fixed rate

When the commercial lending department borrows from the ALM desk, a fictitious liability is created for the lending department

This is mirrored by a fictitious asset created for the ALM desk.


The department then lends the funds to the client, charging them the five-year interbank rate, plus a spread to cover operating expenses and the credit risk

This creates a real asset for the department

The resulting situation is that the lending unit has a real asset and a fictitious, matching liability

The ALM desk has a fictitious asset; that has the interest-rate characteristics of the loan, but without credit risk


On the day of making the loan, the commercial lending department knows that for the next five years it will receive fixed-interest payments from its client and make fixed-interest payments to the ALM desk

At the end of five years, the client will repay the loan, and the lending unit will use the proceeds to repay the ALM deskAt the lending department therefore has locked-in its profit for this transaction and knows that the profit will not change if general market rates change.


By matching the real assets and liabilities with fictitious liabilities and assets of the same maturity, the business units are hedged, and changes in interest-rates will only affect the profitability of the ALM desk

The managers of the ALM desk chose how they wish to deal with this net interest-rate risk

They may choose to hedge it by doing real trades with the external capital market

Or, they may choose to keep it, thereby gaining a net expected profit but requiring the bank to hold additional economic capital to protect it from interest-rate risk

GENERAL RULES FOR- MATCHED-FUNDS- TRANSFER PRICING

Now that we have seen how matched-transfer pricing works for a specific example, let us layout some general rules for setting up a matched-funds-transfer pricing framework.

1st Rule: the funding requirements for all transactions ar

e 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 th

e 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.


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.


After all the internal transactions have been conducted, each business unit has a balance sheet showing its actual assets and liabilities and interest-rate matched fictitious liabilities and assets. The accounting unit charges and credits each business unit with the internal interest payments established by the matched-funds-transfer-pricing agreements and the consequent assets and liabilities on each unit's balance sheet.

Figure 15-6 shows an example of a balance sheet. The real assets and liabilities are shown in bold. The fictitious liabilities and assets are denoted by an as

terisk (*)Let us examine this balance sheet in detail. Starting with the trading unit, we find that it has $30 bi

llion in assets created by long positions, e.g., owning equities.

It has real liabilities of $20 billion in short positions and $5 billion in money that it has borrowed from other banks in the interbank market.

It also has a fictitious liability for $5 billion that it has borrowed from the ALM desk for 1 year. This appears as an asset to the ALM desk

The commercial lending group has made a series of loans to its customers. These are latched by a series of fictitious

loans of similar maturities and almost the same value.

The difference in value is because the true loans are prepayable, whereas the ficititious loans are not normally prepayable.


The retail unit has $40 billion of assets in the form of car loans.

However, the interest-rate on these loans floats and is tied to prime.

Because prime is an administered rate, it is not quite the same as any single market rate, and is therefore best hedged with a series of loans of different maturities, as we discuss later.

The retail unit also has $100 billion of liabilities in the form of checking accounts. Although these accounts are demand deposits, it is unlikely that the whole amount will be withdrawn for at least 2 years, so the bank can be confident in lending out the deposit funds as a mixture of loans from overnight to 2 years.

TRANSFER PRICING FOR INDETERMINATE-MATURITY PRODUCTS

For products such as fixed-rate loans, it is relatively easy to find traded instruments in the interbank and capital markets that can be used to hedge the interest-rate risk.

However, in the balance-sheet example, we introduced the problem of dealing with products such as checking accounts and prime-based loans that have indeterminate" maturities and no fixed relationship to traded instruments.

Products such as these are best hedged using a mixture of instruments.The hedge can include not only bonds, but also options. For example, if customers are able to prepay when rates fall, the lending unit and the ALM desk should enter into an agreement in which the ALM desk agrees to take any prepaid funds. The ALM unit thereby commits to reinvesting the funds at the new market rates, without passing on any losses to the lending unit.

TRANSFER PRICING FOR INDETERMINATE-MATURITY PRODUCTS

In exchange, the ALM unit will charge an option premium to the lending unit when it first funds the prepayable loan. The ALM unit is left to manage or hedge the option as it sees fit.Determining the best hedge for an indeterminate product is difficult.

The best way is to model the payments from the product as described in the chapter on interest-rate risk. The product can then be put into the simulation model along with a series of traded instruments, such as loans and options. The best hedge is then the combination of traded instruments that best matches the product

After applying matched-funds-transfer pricing, the lending units should be left with only credit and operating risk, and the deposit-taking units are left with only operating risk. The ALM desk has the structural interest-rate risk, and the trading group has general market risk, counterparty-credit risk, and operating risk. This is illustrated in Figure 15-7, where the extent of shading reflects the amount of risk

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