Revisiting Funds Transfer Pricing

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Fundamentally, the objectives of funds transfer pricing (FTP) has remained the same as it was when it ...... on behalf of Australian Prudential Regulation Authority.

Revisiting Funds Transfer Pricing By Hovik Tumasyan PricewaterhouseCoopers, LLP∗ † PwC Tower, 18 York Street, Suite 2600, Toronto,ON M5J 082, Canada hovi[email protected]

February, 2012

Abstract Fundamentally, the objectives of funds transfer pricing (FTP) has remained the same as it was when it was first developed. However, in the environment of very low interest rates that preceded the recent financial crisis FTP frameworks in many banks have been left underfunded and underdeveloped. The financial crisis brought FTP into the regulatory spotlight. Regulators expect banks to be able to demonstrate how their FTP frameworks are aligned to the best practice principles for liquidity management. The paper reflects on the fundamental aspects of a FTP framework and its role in a bank. ∗ Views

expressed are those of the author and do not reflect those of PwC or its affiliates. of this article have appeared as a chapter in Asset-Liability Management for Financial Institutions, Bloomsbury Information Ltd., London 2012. † Parts

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Revisiting Funds Transfer Pricing

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Contents 1 Background - The Changing Landscape

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2 How Does FTP Work - The Mechanics 2.1 Pool Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Matched Maturity Approaches . . . . . . . . . . . . . . . . . . . . . . . . . .

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3 Matched Maturity Funds Transfer Pricing 3.1 Transfer Pricing of Assets . . . . . . . . . . . . . 3.2 Transfer Pricing of Liabilities . . . . . . . . . . . 3.3 Methodological Aspects of the Matched Maturity 3.4 Transfer Pricing Equity Capital . . . . . . . . . .

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4 Closing Remarks

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Background - The Changing Landscape

In an environment of very low interest rates that preceded the recent financial crisis many of the funds transfer pricing (FTP) frameworks in banks have been left underfunded and underdeveloped. Because in such environments cost of liquidity is not a constraint enough to feature in the growth strategies at banks, infrastructures for charging for liquidity consumption have remained overly simplistic, lacking scalability and responsiveness. Not surprisingly, in the aftermath of the financial crisis FTP, as one of the fundamental building blocks of bank liquidity measurement and management, was brought into the spotlight of regulatory scrutiny. Recent reviews of the FTP frameworks in banks by the regulators have revealed major functional inefficiencies in FTP systems that run through practically all the dimensions of a FTP framework (see for example, [FSA 2010], [EBA 2010] and also [Grant 2011]). The UK regulators, for example, articulated their requirements for FTP frameworks in a letter to the Treasurers of the banks under their oversight ([FSA 2010]). In particular: Pricing and P&L Attribution • Price all the liquidity costs - funding costs, liquidity premiums, indirect/hedging costs,etc., • Minimize allocation of liquidity costs to the center, • Price and allocate costs of contingency liquidity and stress test buffers. FTP Granularity • Apply FTP to a sufficiently granular level to affect business transaction decision makers, • Aggregate bottom-up the cost of liquidity to performance measurement points. FTP Consistency • Establish an oversight and governance framework around FTP to monitor consistency of its application,

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• Synchronize the funding costs calculations and methodologies across the organization. Responsive FTP Framework • Eliminate over-reliance on offline systems requiring manual intervention, • Revise the simplistic assumptions in the implementation of the FTP framework. Strategic role for FTP • Implement forward looking liquidity cost measures, • Embed FTP revaluation capabilities in stress test scenarios, • Enforce the strategic roles for FTP - a signaling tool to business units and balance sheet steering tool to senior management. FTP has become a regulatory requirement. Regulators expect banks to be able to demonstrate how their FTP frameworks are aligned to the best practice principles for liquidity management ([Basel 2008], [Basel 2010], [IIF 2007]). Given the deliberate efforts by regulators globally to achieve harmonisation in both qualitative requirements and quantitative calibration of liquidity risk management, it would be na¨ıve not to expect that these requirements will soon find their ways into other jurisdictions.

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How Does FTP Work - The Mechanics

In its simplest form FTP is the process wherein the Treasury of a bank (its funding center) aggregates funds centrally and then redistributes them throughout the business units, balancing funding resource excesses and shortages, thus creating an internal market for liquidity. If there is still a deficit for funds, Treasury raises more funds from the capital markets, and if there is an excess of funds Treasury invests them or lends in the wholesale markets. FTP has been an integral part of bank management for over three decades. It traces its origins to the 1970s and the deregulation of interest rates in the U.S., when it was developed as a tool for managing the interest rate risk in banks1 . Fundamentally, the purpose of an FTP still remains the same as it was when it was first developed - aggregate the interest rate exposure of the whole bank into a central location for its effective management. However, in doing so, FTP generates a few other results that are sometimes quoted as main purposes for FTP: • By transferring the interest rate risk into a central location, it makes the balance sheets of business units immune to interest rate fluctuations, • By charging for such transfers, it effectively determines the net interest income of business units, 1A

selective history of these events can be found in [van Deventer et al. 2005].

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• Because banks acquire interest rate exposure in the process of funding their balance sheets, FTP is perceived as well to be the mechanism of charging for funding costs and as a tool to manage liquidity risk of the bank. It has to be noted however, that equating management of interest rate risk to allocating the costs for funding can be an oversimplification in today’s banking organizations. The simplistic and directional view that higher interest rates increase the costs of funding and this risk needs to be managed against seems to be a reminiscent of times where all the loans (mortgages) in the banking books were fixed rate (as far back as the 70s and 80s). Today banking books have almost as much of variable rate loans indexed to a variety of alternative indices (which create basis risks) as they have fixed rate loans. Moreover, interest rate management transactions sometimes are carried out between a banking unit (like retail) and a swap desk in the Capital Markets division, while the Treasury charges a fixed rate for an overall use of funding resources2 . In the aftermath of the recent financial crisis, FTP has regained its prominent role as the key tool in measuring and managing the liquidity risk in banks. We will follow the funding cost allocation side of the FTP and will acknowledge the interest rate exposures aspect in passing, distinguishing between the two in examples. The mechanism of FTP is dictated by the very nature of the banking business. In the course of their day-to-day business banks either lend or take deposits independently. As a result, business units either end up being short of funding for lending or in excess of it and are looking to invest. The Treasury of the bank owns the process of transferring the funds internally from businesses that have the excess to the ones that need the funding. In the process Treasury charges a rate for the funds provided to, and pays a rate for funds purchased from the business units (the FTP rate). This results in a decomposition of the net interest margin (NIM) of the bank into three components - the lending business NIM, the deposit business NIM and the Treasury NIM (here Treasury NIM and FTP NIM are the same and will be used interchangeably). Fig.1 illustrates the FTP process and decomposition of thee NIM. In this example Treasury (its funding center) has acquired $1, 000 of deposits at 3%, to fund a loan of the same amount, passing the 3% rate as an FTP rate to the lending unit as an interest expense. In this transaction neither the bank as a whole nor the units involved (including the Treasury) have taken interest rate or liquidity risks, as reflected in the zero FTP NIM of the Treasury. Notice that the bank NIM of 4% is composed of the three NIMs N IMLending + N IMDeposits + N IMT reasury = 3% + 1% + 0% = 4%. Fig.1 is the simplest of the situations that can occur in a bank. Normally, the deposits are of shorter terms than the loans. So there is a maturity mismatch that creates both interest rate and liquidity risk exposures. An example of this is shown in Fig.2 below. Here the same 5-year loan of $1, 000 is funded by acquiring $1, 000 of 2-year deposits from depositors at 2 While there can be a few things that can go wrong with such a setup, the two more significant ones seem to be the conflict of interest in the positioning of the swap desk and the practical non-feasibility of forming an aggregate view of the interest rate exposure for the bank as whole. Nevertheless, today such practices are fairly wide spread to be ignored.

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Figure 1: The mechanics of FTP - no interest rate or liquidity risks. 1%. First, notice that the bank in this scenario generates a greater NIM of 6% − 1% = 5%. To achieve this the bank exposes itself to the risk associated with being able to roll the 2-year deposit until the loan is repaid (liquidity risk) and the risk of paying higher rates for the 1-year deposits if the interest rates go up in the process (interest rate risk). As can be seen from the Fig.2, FTP process has moved both risks into Treasury, plus the extra 1% NIM for assuming the responsibility of managing these risks. So the basic question arises, how does the Funding Center decide how much to pay and how much to charge for the funds it acquires and re-distributes (the 3% in Fig.1 and 2% in Fig.2?) To develop the discussions further we will maintain the business structure described in Fig.1 and Fig.2 - a lending unit, a deposit unit and the Treasury. We will also assume that the Treasury owns a Funding Center, which runs a FTP book that has all the transfer priced assets and liabilities of the bank. At a fairly high level there are two main approaches that Treasuries employ to determine the FTP rate applied to business units and the funding center - pool approach (single and multiple pool approaches) and matched maturity approach.

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Figure 2: The mechanics of FTP - with interest rate and liquidity risks aggregated to the Treasury.

2.1

Pool Approaches

In the simplest case the Funding Center nets the excesses of some business units with the deficits of others. A central pool lends to deficit units and purchases the excesses from others and uses the same rate for both (see Fig.3 below). It is a simple approach, but has drawbacks that are difficult to ignore. First, since the assets and the liabilities are matched at the business unit level before identifying the shortfalls and excesses of funding resources, the Funding Center does not know the maturity profile of the pools and will operate on an average rate basis. As such it will always leave both interest rate exposures as well as funding costs unmatched. Furthermore, since it has no control over the business unit operations the maturity mismatch profile of the excess pool or the funding required is not known to the Funding Center a priori. The size of the unknowns and the success of such a simplistic framework depend on how homogeneous the products of the respective business units are. Therefore, in today’s banking environment where products are increasingly structured and with embedded contingent cash flows, the single pool approach is increasingly looking like an oversimplification. The next level of sophistication in FTP approaches moves in the directions of the shortfalls of the single pool approach and is referred to as a multiple pool approach. This approach acknowledges the maturity structure during the netting of the assets and liabilities of the

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Figure 3: Single pool approach to funds transfer pricing. business units, as well as product-specific features to produce pool-specific FTP rates. Pooling may be based on maturity structures of the products, re-pricing of indices, as well as other specifics like behavioral patterns. While a clear enhancement, the approach still suffers from dependencies on pool averages and assumptions made about the acceptable level of granularity and the number of pools how many pools adequately reflect the maturity mismatch profile and the funding costs of the bank as a whole correctly?

2.2

Matched Maturity Approaches

The approach that is recognized today as the most adequate one for achieving the goals of an FTP framework is known as the matched maturity transfer pricing. Under this approach, FTP rates charged for the use of funds and rates credited for providing funds are based on matching the rate on the cost of funds curve to the maturity (or the arrival/departure time of each principal cash in/out flows) of the asset or the liability instruments. To do so, all the assets and the liabilities are first transferred into a central book referred to as the FTP book Fig.4. This is structurally different from the pool approaches in Fig.3 and serves both goals of FTP - allocation of the cost of funding and construction of the interest rate risk exposure for structural risks hedging (both for structural interest rate and foreign exchange risks). Variations exist to the picture in Fig.4. For example, pools could still be formed after all the assets and liabilities have been transferred into a FTP book transaction by transaction.

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Figure 4: Matched Maturity approach to funds transfer pricing. This is however counter-productive, since it loses the level of granularity that generates the precision in assessing the liquidity profile and interest rate risk. Experience shows that the moment banks move to multiple pool approaches, the incremental effort to make the switch to maturity matched transfer pricing becomes smaller and smaller, and banks usually adopt the latter as an approach for the whole balance sheet. For this reason in the remainder of this paper we will discuss the various aspects of funds transfer pricing using the matched maturity approach.

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Matched Maturity Funds Transfer Pricing

A matched maturity of funds approach to FTP is currently considered to be the most adequate one by many practitioners. As mentioned before, under this approach rates charged for the use of funds and rates credited for providing funds are based on matching the maturity profile of principal cash flows of asset and liability instruments to the FTP rate that corresponds to that maturity on the cost of funds curve (an example of such curve is shown in Fig.5). After this rate is identified, shadow interest expense (credits) to assets and shadow interest income (debits) to liabilities of the business units are created following a double entry accounting mechanism. Simultaneously, mirror positions of these shadow entries are created in the FTP book. We will first follow a few key examples to illustrate the mechanics of funds transfer pricing of assets and liabilities using the matched maturity approach. We then will explore some of the theoretical aspects of this approach. Parallel to assigning FTP rates and the calculation of the NIMs created, we will identify the interest rate risk exposures for each of the cases discussed and will plot the maturity mismatches according to the liquidity risk created. We will use the FTP curve in Fig.5 as our working example for the transactions discussed bellow.

Figure 5: An example of a FTP curve.

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Transfer Pricing of Assets

Consider a 5-year loan that pays 6% annual interest. The FTP book reflects the matched maturity funding of the loan, where the FTP rate of 3% is picked from the 5-year point on the cost of fund curve (see Fig.5) of the bank and is passed through to the lending unit as an interest expense. Such a transaction fixes the net interest margin across the whole bank at 3% (6% − 3% = 3%).

Figure 6: Transfer pricing a fixed rate loan. As can be seen from Fig.6, this transaction does not create either an interest rate exposure or liquidity risk, since both interest rates are fixed and principal cash-flows are matched in time. The only risk that the loan carries for the bank at this point is the default risk of the borrower, management of which is the main competency of the business unit. Fig.7 illustrates how interest rate exposure and liquidity risk are acquired for the same transaction due to variations to this simple picture resulting from taking a view on either liquidity or the interest rates. The Funding Center (which runs the FTP book), is of the view that wholesale markets are liquid enough and it will be able to roll the wholesale funding position at the end of the first year either for another year or borrow at more beneficial 4-year rates at that time. The Funding Center has created an extra net income margin of 1% in the FTP book and has

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Figure 7: Transfer pricing a fixed rate loan with views. enhanced the bank NIM overall, albeit by taking liquidity and interest rate risks. The interest rate risk taken by the Funding Center needs to be also allocated an adequate amount of risk capital. Consider now the same 5-year loan that instead pays an interest indexed to 1M LIBOR and equal to LIBOR + 350bps. The Funding Center funds the loan with a 5-year floating rate note indexed to 1M LIBOR, for which it pays 1M LIBOR + 50bps. The 50bps spread is referred to sometimes as the liquidity premium. The funds transfer pricing of a floating rate loan creates the balance sheets and net interest margins shown in Fig.8. Again, in this example we have matched the interest rate index (and its tenor) explicitly, which generates a zero NIM for the FTP Book and locks a 300bps NIM for the business unit, which in its turn rolls up to the NIM for the bank as a whole. No interest rate or liquidity risk has been acquired. In this situation, however, there are a few things that the Funding Center could do to take a view - create exposures to liquidity risk (maturity mismatch), take interest rate risk (by funding at a fixed rate or at different terms) and generate a basis risk (by mismatching the index or its tenor). All of these actions create the same situation where the funding center is taking risks (different risks and different mechanisms, but the same outcome) and has to

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Figure 8: Transfer pricing a floating rate loan. provide return on the capital allocated for covering those risks3 . We illustrate in Fig.9 only one of these cases, where liquidity risk exposure gets created by a maturity mismatch. In this case the Funding Center takes a view that the bank-specific asset swap spreads will tighten (and hence the liquidity premiums will decrease). Accordingly the funding center is funding the 5-year floating rate loan with a 1year floating rate note, indexed to the same interest rate. Fig.9 shows the balance sheets and the net interest incomes of the business unit, funding center and the bank as a whole. This of course creates the liquidity risk of not being able to roll the 1-year note in one years time or issuing a 4-year note on the same terms. It also exposes the bank to the volatility in asset swap markets, with the risk of spreads widening at the short end of the term structure. 3 Allocating

risk capital to liquidity risk exposures usually does not help mitigate liquidity risks, so we are talking about allocating capital to interest rate and basis risk.

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Figure 9: Funds transfer pricing a floating rate loan with a view. In the examples considered so far principal cash flows of the loans were arriving at maturity. This is usually not the case, and when principal cash flows come with a certain schedule they need to be matched to their time of arrival, not the maturity of the transaction. This creates a principal cash flow weighted FTP rate to be assigned to the whole transaction. An example is shown in Fig.10. Here the FTP rate is 2.20%, not 3.00% as it would have been in the case of a single principal cash flow at the maturity point (5 years).

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Figure 10: Principal cash flow weighted FTP rate calculation.

3.2

Transfer Pricing of Liabilities

As the banking industry was reminded during the recent financial crisis, deposit collecting businesses are providers of very valuable funding sources. Because banks offer deposits at much lower rates than the rates on available wholesale funding, FTP allocates this opportunity cost benefits to the deposit collecting units. Consider, for example, a certificate of deposit of $1, 000 offered by a bank that pays 1% to the holder in 1 year time. The deposit unit sells the funds raised to the Treasury at the price of the analogous 1year funding available from the wholesale markets (Fig.11), which is 2% at that point in time (cfr. Fig.5). This transaction does not create any interest rate or liquidity risk, because the terms of the both sides of that particular transaction are matched. In the examples above the loans were matched with a deposit product of an equal maturity for the sake of simplicity of the exposition of maturity matched approach to FTP. In reality, however, deposits fund banking assets with maturities much longer than the deposits. So inevitably, funding loans with deposits creates a negative maturity mismatch for banks. Such a direct interpretation (or use) of the deposit contracts would infer that banks have to refinance some portion of their deposits almost daily, to cover these negative maturity gaps. Herein, however, hides the real value of the deposit businesses for a bank that many deposit businesses feel that FTP frameworks do not give enough credit for, when the matched maturity approach is implemented as mechanically as above. Deposit products at a high level can be divided into two main categories term and non-

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Figure 11: Funds transfer pricing deposits. term, and both can be interest bearing or not. Truth of the matter is, however, that deposits hardly ever behave as they are contracted to. For example, customers with term deposits may decide to roll forward (sometimes even with increased balances), rather than withdraw the expired deposit contracts. On the other hand, a deposit instrument with no stated maturity contains no penalties for withdrawing the whole balance on the account with no or little notice (a no-cost put option in the contract design). So to understand the behavior of the deposits from the standpoint of the behavior of principal cash flows and the associated ”liquidity value” one has to view them in bulk and with respect to the macro-environment (interest rates, economics and other collective behavioral specifics). In bulk deposit balances demonstrate stable patterns or ”stickiness” with liquidity life characteristics resembling those of a term debt. This is of course of fundamental economic benefit to the banks, and as such should be reflected in the FTP methodologies to create the right incentives in the growth of deposit business lines [McGuire 2004] and [Turner 2008]. Consider, for example, a situation where a large portion of 1-year deposits rolls into another 1 year holding period at least twice. This creates a cash outflow with a 3-year tenor, with the cost of a 1-year deposit. The bank will be able to fund a 3-year loan from the pool of such sticky deposits (see Fig.12). Bank’s NIM is again a combination of the NIMs for the deposit unit - 1.70%, the lending unit - 1.30% and the FTP book - 0%, equal to 3% = 4% − 1%.

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Figure 12: Funds transfer pricing premium for ”sticky” deposits. The 1.70% margin for the deposit unit can be decomposed into two components - wholesale market component - 100 bps and a stickiness component - 70 bps (Fig.13). While the

Figure 13: Decomposition of the FTP rate for sticky deposits. wholesale component is an external to the deposit unit (and the bank) factor, the stickiness component is driven by the behavioral characteristics of the bank deposits. Notice as well, that the success of funding the bank assets with sticky deposits in a liquidity risk neutral manner (neither the bank, nor the deposit and lending business units incurred maturity mismatches, in Fig.12) rests entirely on how well the deposit unit knows its customers and how well it tailors the deposits products to create more of the type of deposits that exhibit reliable sticky behaviors.

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Methodological Aspects of the Matched Maturity Approach

Firstly, let’s acknowledge that in all the examples considered above the matched maturity FTP mechanism has achieved the following: - the liquidity and interest rate risks where aggregated into a central point in the bank, - business unit P &L’s did not carry interest rate exposures, neither were they exposed to liquidity risk, - the liquidity risk and interest rate exposure of the FTP book, as well as its P &L for those exposures matched that of the bank as a whole, - the views on liquidity risk and expectations about the interest rates were taken at the appropriate point in the organization, where it can be measured and managed, - the point where risk capital for (structural) interest rate risk exposure of the bank should be allocated was made easily identifiable. The last bullet point has implications for the question whether the Funding Center should be a profit or a cost center. In the most general case it can be a profit center in terms of the NIM, but a cost center with respect to economic profit or on a required return on equity basis. The size of this cost center (together with other contributing factors) could help determine the level of the risk tolerance for interest rate and liquidity risk for the bank as a whole. Because banks lend and borrow through hundreds of transactions a day, a functioning and self-consistent FTP framework, built on solid theoretical fundamentals is required to enable revelation of the implied views/bets on liquidity and structural risks embedded in a banks balance sheet that form over time, one transaction at a time. One of the most central elements that form the methodological foundations for calculating the funds transfer pricing rate in the matched maturity FTP approach is the choice of the benchmark cost of fund curve (like the one in Fig.5). The choice of such a curve reflects (or implies) both the philosophy and the approach to managing liquidity and structural interest rate risk on the balance sheet of a bank. Usually, once this curve has been chosen, banks have a few add-on spreads to it that range from bank-specific direct and indirect operating costs to spreads for optionalities embedded in the transfer priced instruments (e.g., prepayments in mortgages or putable deposits, costs of holding a portfolio of liquid assets, ect.). From microeconomics standpoint, it can be shown that the optimal transfer price for an intermediate good between two business units is its opportunity cost [Hirshleifer 1956]. Furthermore, if the units are free to determine their own outputs4 and the market for the intermediate good is competitive then the optimal transfer price for it is its marginal cost in the market. In the case of funds transfer pricing, where the intermediate good is the funds from depositors, the choice for the benchmark cost of funds curve becomes the curve for marginal cost of funding for the bank in the wholesale markets[Ford 2009]. For banks that 4 For example, how much the lending business lends does not affect how much deposit is taken in and the imbalances in divisional outputs can be met in the external market.

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have active access to funding in the wholesale markets, this curve has been the AA curve for a while, which roughly reflects the ratings of almost all wholesale market participants. For more than a decade before the crisis this curve has been practically replaced by the swap curves, reflecting (among other things) the short-term nature of funding of bank balance sheets. the spread between the two curves hovered around 10 bps for a very long time. The recent financial crisis showed that this spread is as volatile as the curves themselves and can have a non-trivial term structure. FTP methodologies should capture both the size of this spread as well as its term structure. This spread appears in the FTP parlance as the liquidity premium. In some organizations there is a cultural misconception that being charged this premium is a punitive measure. This sometimes can be traced to a methodological misconception that matched term means matching the tenor on the index of a variable rate loan (for example, 1 month LIBOR), rather than its maturity term, overlaid with the expectation that the loan can be funded by rolling this short term funding. Another methodological misconception is around the choice of a single or multiple benchmark cost of funds curves. For example, banks may select a special mortgage curve to transfer price mortgages while using the institutions wholesale funding curve for all remaining assets and liabilities. Mortgages are especially appealing candidates for separate benchmarks since these assets have counterparts, such as mortgage portfolios and mortgage-backed securities, which are traded in financial markets. While this may make the multiple curves option seem reasonable at first glance, the actual consequences turn to be contrary to what an FTP is trying to achieve, i.e. inaccurate hedging, incorrect measurement of treasury/funding center performance and misguided product pricing [Shih et al. 2000]. The other essential component in building the FTP framework is the development of the maturity profile for the deposit products of the bank. Despite the fact that banks have ample amount of historical data, the development of a single well-understood approach to constructing the maturity profile of the deposit portfolios remains a little more than an artisan craft in many banks today. One of the two widely used approaches is the tranching approach whereby the analysis determines a portion or ”tranche” of a pool of appropriately chosen deposit products as ”core” or long-term stable tranche, based on historical analysis of past cash flow patterns in balances. This tranching continues until some amount is apportioned to a ”non-core” or volatile tranche. Accordingly, the stable or core tranche of the deposit pool gets a long-term FTP rate matched to it, while the non-core tranche gets assigned to it a short-term FTP. The practice of what’s a short-term and what’s a long-term maturity appropriate for these tranches has a very dispersed range of values between banks. The two together determine a blended FTP rate for the pool of deposits under the analysis. The second, simulation based, approach models both the balances and the interest rates on deposit products through factor models with stochastic terms. The types of factors used are usually split into two groups the interest rate and macro-environment (current rates

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offered, competitor rates and fees, etc.) and the pool specific factors (levels of service and convenience, customized products, customer mobility, local demographics, etc.). The simulation allows forecasting maturity profiles of deposit pools which can be used for assigning maturity matched FTP rates. The resulting maturity profile in this approach is considerably more granular and lends itself to more flexible and proactive deposit pricing and/or liquidity management. A third methodology uses replicating portfolio approach, whereby the historical cash flow behaviors of the deposit pool are replicated by a portfolio of risk-free instruments (sometimes both cash and derivatives). Unfortunately, as with any replicating portfolio approach, the resulting liquidity profiles and FTP rates tend to be extremely sample dependent and unstable in time. Consequently, this approach has struggled to achieve as wider acceptance as the first two. In the aftermath of the recent financial crisis and the acute dependence of banks on more stable and diversified funding sources, banks have found themselves in need of more comprehensive study and model building for their deposit pools. The difference between getting the FTP fundamentals right or wrong when building a FTP framework can be the difference between a functioning and disfunctional FTP framework.

3.4

Transfer Pricing Equity Capital

Equity capital plays a special role in a bank. The presence of the adequate to the asset risks amount of equity capital allows banks to borrow at favorable rates in capital markets. As a result, all (risky) assets on a balance sheet of a business unit are funded with debt capital with only few exceptions. More typically, equity capital gets allocated to the risky assets of the business units as a risk capital - to cover potential losses, and is consequently used for performing risk/return and portfolio analysis. The cost of equity capital that should be charged for the two cases - equity funding and risk capital allocation, are different. In the first case it is the full cost of equity capital equal to the required return on equity5 charged to the business unit as a transfer price for the equity capital used for funding. In the second case, it is the full cost of equity capital less the return on a risk-free investment (it is the same risk-free rate that goes into the estimation of the cost of equity capital) applied to the amount of risk capital allocated. This netting of the cost of equity capital with a risk-free rate happens in the form of an equity credit rate, credited to the business unit P &L. 5 The required return on equity capital is usually measured as risk-free rate + beta of the bank × equity market premium.

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When and how much of such a credit should be applied, has a wide variety of interpretations and calculation methodologies throughout the banking industry. The industry practice seems to revolve around two main candidates for the equity credit rate - a long-term FTP or a risk-free rate, both calculated top-down in most cases and often with some misguided reference to the duration of the equity. The correct equity credit rate is different for the two cases of capital consumption. Fig.14 illustrates the equity credit rate calculation for the case where equity capital is allocated as a risk capital to the business unit.

Figure 14: Transfer pricing equity capital - risk capital allocation. The case for which the FTP rate enters the equity credit rate calculation arises when an asset is partially funded with equity capital, but the FTP system has booked it as a fully debt-funded asset (see also [Shih et al. 1997]. In such cases the equity credit rate becomes a ”blended rate”. This is illustrated in Fig.15. The FTP rate is credited back to the business unit P &L, applied to the equity-funded portion of the asset and simultaneously the cost of equity capital is charged to the P &L as the cost to the portion funded with equity. And since the whole transaction needs to be charged the transfer price for the allocated risk capital in the form of the netted cost of equity capital as described above, the equity credit rate becomes a weighted average rate between the FTP rate and the risk-free rate. Notice

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Figure 15: Transfer pricing equity capital - risk capital allocation and equity funding of assets. that now the economic profit for the business unit is lesser by $3, which is the difference between the equity and debt funding (9% − 6%) applied to the amount funded by equity capital ($1, 000 − $900), the more expensive form of capital. An explicit derivation of a formulaic expression for the equity credit rate can be found in [Tumasyan 2010].

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Closing Remarks

A faulty FTP methodology or a biased FTP framework will send wrong signals one transaction at a time, over time creating an unintended balance sheet structure in the form of disproportionate mix of asset portfolios on the asset side (e.g., the size of subprime loans and trading portfolios), and/or liquidity holes on the liability side (e.g., Northern Rock). In many respects an effective FTP function is the first line of defense for a bank’s balance sheet and its business model.

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References [van Deventer et al. 2005] Donald R. Van Deventer, Kenji Imai and Mark Mesler Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. Singapore: John Wiley and Sons (Asia) Pte Ltd.(2005). [McGuire 2004] McGuire, W. J. (May, 2004). Indeterminate Term Deposits in FTP: Quantified Solutions at Last! Journal of Performance Management,pp. 14-26 [Turner 2008] Turner, S. (2008). Funds Transfer Pricing:Cracking the Code on Deposit Valuation. Novantas White Paper Series, 1-4 and references there in. [Cornyn et al. 1997] Cronyn, A. G., Klein, R. A., and Lederman, J. (1997). Controlling and Managing Interest Rate Risk. Prentice Hall Pr. for a review of such models, [Dewachter et al. 2006] Dewachter, H., Lyrio, M., and Maes, K. (2006), A multi-factor model for the valuation and risk management of demand deposits. National Bank of Belgium [Kalkbrener et al. 2004] See for an example Kalkbrener, M., and Willing, J. W. (2004). Risk management of non-maturing liabilities. Journal of Banking and Finance, vol. 28, 15471568. [Brickely et al. 1995] See for example, Brickley, J., Smith, C., and Zimmerman, J. (Summer, 1995). Transfer Pricing and the Control of Internal Corporate Transactions. Journal of Applied Corporate Finance , 60-67, [Hirshleifer 1956] Hirshleifer, J. (1956). On the Economics of Transfer Pricing. Journal of Business, 29 , 172-174 [Ford 2009] Ford, G. (2009). Internal Pricing in Financial Institutions: Issues. Macquarie Graduate School of Management. [Shih et al. 2000] See Shih, A., Wofford, S., and Crandon, D. (2000). Transfer Pricing: Pitfalls in Using Multiple Benchmark Yield Curves. Journal of Performance Management , 33-46. [Tumasyan 2010] Tumasyan, H. Credit Where Equity is Due. Available at www.ssrn.com [Kipkalov 2009] Kipkalov, A. (2009). Transfer Pricing Capital. Journal Of Performance Management , 38-46 [Shih et al. 1997] Shih, A., and Tavakol, A. (1997).Making Sense of the Transfer Pricing of Equity. Bank Accounting and Finance, 47-52. [IIF 2007] See also Institute of International Finance. (March, 2007). Principles of Liquidity Risk Management. [Basel 2010] See Basel III: International framework for liquidity risk measurement, standards and monitoring. Basel Committee on Banking Supervision, December 2010.

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[Basel 2008] Principles for Sound Liquidity Risk Management and Supervision, Basel Committee on Banking Supervision. September, 2008 [EBA 2010] European Banking Authority Guidelines on Liquidity Cost Benefit Allocation, October, 2010 [FSA 2010] Financial Services Authority, Dear Treasurer Letter, July, 2010. [Grant 2011] Grant J., Liquidity transfer pricing: A guide to better practice, March, 2011 on behalf of Australian Prudential Regulation Authority.

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