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Bank Internal Transfer Pricing: One More Issue for Regulatory Authorities

by Dr Moorad Choudhry

The UK Financial Services Authority (FSA) issued a number of consultative papers in 2008 and 2009 that concentrated heavily on bank funding liquidity. The proposals are being debated at all levels but it is apparent that UK banks will have to adhere to a much stronger regime with regard to liquidity risk management. Comprehensive as the FSA review as been, it does not address to any large extent the issue of internal bank funding. Internal transfer pricing is a key issue in the business decision, and many banks have operated an artificial internal funding mechanism for their various business lines. We believe that in omitting to address the bank internal funding process, the FSA has missed targeting a key risk issue.

In this article we consider how internal transfer pricing can become a cause of poor business decision making when it is applied at levels that take no account of the risk-reward profile of the business being entered into. We also provide recommendations how the internal funding mechanism can be applied in a more robust and disciplined manner.

The Internal Funding Price

The recent review by Lord Adair Turner, Chairman of the FSA, on the future of bank regulation, emphasised a more robust approach to bank liquidity risk management. In due course UK-regulated banks will have to demonstrate, among other things, the following features of their liquidity management policy:

an increased self-sufficiency in funding;

a more diversified funding base;

a longer average tenor of liabilities; and

a “liquidity buffer” of high quality government securities.

These recommendations are to be welcomed and should, over time, be seen as part of a wholesale paradigm shift in the basic banking business model, which had hitherto relied excessively on short-term and wholesale, undiversified funding. However, the Turner report and various FSA Consultation Papers on Liquidity and Funding 1 do not address a further critical issue in banking operations: how funds are managed internally. In reality, the way that banks structure their internal transfer pricing can influence significantly their risk-reward profile and the activities of individual business lines. Therefore, it is important that a bank’s internal funding framework is placed under scrutiny, with guidelines enforced by the regulator when deemed necessary.

From the practitioner viewpoint, banks can also gain a competitive advantage if their internal funding mechanism is operated effectively.

Pro-cyclical funding

It is common to seek to strengthen external regulation during a crisis, although paradoxically this is precisely the time when it is least needed. By then, bank senior management is keen to

1 CP 08/22 Strengthening Liquidity Standards (December 2008); CP 08/24 Stress and Scenario Testing (December 2008); CP09/13 Strengthening Liquidity Standards 2: Liquidity Reporting (January 2009)

retrench ultra-conservative lending practices, and needs little encouragement or intervention to do so. It is this risk aversion in a falling market, as has been well documented, which exacerbates the impact of a “credit crunch”. The need for tighter supervision is at its greatest at the top of a bull market, when lending and allocation decisions are looser.

By the same token, organisations are less likely to address internal processing inefficiencies when they are cash-rich and with revenues growing, when in fact the cost and opportunity to implement such efficiency gains are at their most benign. A rising cost-income ratio is one of the first signs that the economic cycle for an institution has turned, by which time it is too late to instigate effective cost reduction strategies (large scale redundancy notwithstanding).

So, just as we are now witnessing a steady flow of supervisory proposals addressing the twin tenets of financial health and stability in the banking world – solvency and liquidity – we are also seeing banks fight rearguard actions to address shortfalls in their capital adequacy and liquidity assessment capabilities. All of this comes at a time of severe economic contraction and negative consumer and capital market confidence.

Liquidity and Funding

It is in the areas of liquidity and funding risk management where an external/internal dichotomy can be seen to be in play. The management of liquidity risk, defined as the risk of being unable to raise funds to meet payment obligations as they fall due, and to fund increases in assets, and funding risk, which is the risk of being unable to borrow funds in the market, 2 is the current focus of three separate consultation papers issued by the FSA.

The move towards prescriptive (rather than principles-based) regulation that characterises capital adequacy compliance under Basel 2 would appear also to be crystallised in these papers, as is the emphasis not just on more detailed reporting and disclosure requirements but on the mechanisms in place to compute that data. In adding the methods to produce, collate, aggregate and transform cash flow data, as well as the policies that govern these processes, into the remit of these new regimes, the regulator is setting an Individual Liquidity Adequacy Standard (ILAS) against which organisations are assessed (through an ILAA - Individual Liquidity Adequacy Assessment), which is analogous to the Capital Adequacy assessment of Pillar 2 of the Basel 2 Accord.

The prescribed mechanism to manage and mitigate liquidity and funding risk (including in the case of the latter, risks related to wholesale and retail liabilities, inadequate funding source diversification and asset marketability, inter alia) is notable for its focus on the type, tenor, source and availability of funding, exercised in normal and stressed market conditions.

This emphasis on liquidity is correct, and an example of a return to the roots of banking when liquidity management was paramount. While bank capital levels are a necessary part of bank risk management, they are not sufficient. The examples of Bradford and Bingley and Northern Rock were more a failure of liquidity management than capital erosion. Hence it is perhaps not surprising that there is now a strong focus on the extraneous considerations to funding.

However, the use of that funding within organisations, the internal funding framework, including the price at which cash is internally lent or transferred to business lines, has not been as closely scrutinised. This issue needs to be addressed by regulators because it is a

2 See Choudhry, M., Bank Asset and Liability Management, John Wiley & Sons, 2007

driver of bank business models, which were shown during 2007-2008 to be flawed and based on inaccurate assumptions.

An Effective Internal Funding Framework

While the FSA consultation paper does touch on banks' internal liquidity pricing, 3 the coverage is peripheral. However, it is a key element driving a bank’s business model. Essentially, the price at which an individual business line raises funding from its Treasury desk is a major parameter in business decision making, driving sales, asset allocation, and product pricing. It is also the key hurdle rate behind the product approval process and in an individual business line’s performance measurement.

Just as capital allocation decisions affecting front office business units need to account for the cost of that capital (in terms of return on regulatory and economic capital), so funding decisions exercised by corporate treasurers carry significant implications for sales and trading teams at the trade level. Given this fact, banks should aim to develop a comprehensive framework for internal funding.

In an ideal world, it is crucial that the price at which cash is internally transferred within a bank reflects the true economic cost of that cash (at each maturity band), and accurately reflects the risk-adjusted value-at-risk of the business line in question. This will ensure that each business aligns the commercial propensity to maximise profit with the correct maturity profile of associated funding. From a liquidity point of view, any mismatch between the asset tenor and funding tenor, after taking into account the “repo-ability” of each asset class in question, should be highlighted and acted upon as a matter of priority with the objective to reduce recourse to short term, passive funding as much as possible.

Effective reporting is part of the internal funding mechanism. Middle Office or Operations needs to ensure that funding projection is calculated and reported daily, to ensure that the bank carries a flat cash position at the end of the trading cycle. The need for greater cohesion to enforce greater collaboration between these groups becomes compelling, given the impact of any disparity between perceived and actual views of the world on lost opportunity and direct interest rate costs. It is important that the internal funding framework be transparent to all trading groups, and is supported by effective processes and technology; for example timely data transfer between front office and settlement systems, and from external correspondent/agent banks, that must be underpinned by cash flow information sourced from the general ledger. This is essential to the funding mechanism.

A measure of discipline in business decision-making can be enforced via the imposition of minimum return-on-capital (ROC) targets, adjusted for the relative risk of the asset. Independent of the internal cost of funds, a business line would ordinarily seek to ensure that any transaction it entered into achieved its targeted ROC. However, relying solely on this discipline measure may not be sufficient. For the measure to work, each business line should be set ROC levels that commensurate with their (risk-adjusted) risk-reward profiles. However, banks do not always set different target ROCs for each business line, which means that the required discipline breaks down. Second, a uniform cost of funds, even allowing for different ROCs, will mean that the different liquidity stresses created by different types of assets are not addressed adequately. For example, consider the following asset types:

3 See page 23, FSA CP 08/22, Strengthening Liquidity Standards , December 2008

a 3-month interbank loan;

a 3-year floating rate corporate loan fixing quarterly;

a 3-year floating-rate corporate loan fixing weekly;

a 3-year fixed-rate loan;

an 8-year floating rate synthetic CDO note;

a 10-year floating-rate corporate loan fixing monthly; and

a 15-year floating-rate project finance loan fixing quarterly.

We have deliberately selected these types to demonstrate the different pressures that each type of asset places on the Treasury funding desk (the lowest funding rollover risk first). Even allowing for different credit risk exposures and capital risk weights, the impact on the liability funding desk is different for each asset. We see then the importance of applying a structurally sound transfer pricing policy.

Cost of Funds

We have noted that as a key driver of the economic decision-making process, the cost at which funds are lent from central Treasury to the business lines needs to be set carefully, and at a rate that reflects the true risk position of the individual business line. If it is artificial, there is a risk that transactions are entered into that produce an inflated profit. This profit will reflect the funding gain, rather than the true economic value-added of the business.

There is considerable empirical evidence on the damage that can be caused by artificially low

transfer pricing. In their paper, Adrian Blundell-Wignall and Paul Atkinson

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(2008) discuss

the heavy losses suffered by UBS AG in its structured credit business, which originated and invested in collateralised debt obligations (CDO). They quote a UBS shareholder report that stated,

“…internal bid prices were always higher than the relevant London inter-bank bid rate (LIBID) and internal offer prices were always lower than relevant London inter-bank offered rate (LIBOR).” (p 97)

In other words, UBS structured credit business was able to fund itself at prices better than in the market (which is implicitly inter-bank quality and risk), despite the fact that it was investing in assets of lower liquidity and quality than inter-bank risk. There was no adjustment for tenor mismatch (to better align term funding to liquidity). A more realistic funding model was viewed as a “constraint on the growth strategy”.

This lack of funding discipline undoubtedly played an important role in the decision making process, because it allowed the desk to report inflated profits based on low funding costs. As a stand-alone business, a CDO investor would not expect to raise funds at sub-LIBOR, but rather at significantly over LIBOR. By receiving this artificial low pricing, the desk could report super profits and very high return-on-capital, which encouraged more and more risky investment decisions.

On 30 June 2009 The New York Times reported on the KBC Bank NV case. Its derivatives trading arm, KBC Financial Products, was funded by the parent at a fixed spread funding rate

4 Blundell-Wignall, A. and Atkinson, P., The Sub-Prime Crisis: Causal Distortions and Regulatory Reform, Working Paper, OECD, July 2008

of LIBOR plus several basis points. The firm’s asset portfolio however, invested in CDO bonds that were exposed to securities with a rating as low as BB. Much of the profit reported by the CDO business was an artificial funding gain (which took no account of the risk weight of the assets), rather than true economic value-added. The firm’s hedge fund derivatives desk operated on a similar basis, extending loans to hedge funds or fund of funds via long-term products that were illiquid (and hence, difficult to unwind), while funding itself at the same low LIBOR-plus transfer price.

Many banks operate on a similar model, with a fixed internal funding rate of (say) LIBOR plus 15 bps for all business lines, and for any tenor. However, such an approach does not take into account the differing risk-reward profiles of the businesses. The corporate lending desk will create different risk exposures for the bank compared to the CDO desk, and the project finance desk, among others. For the most efficient capital allocation, banks should adjust the basic internal transfer price for the risk exposure of the business. Otherwise they run the risk of excessive risk taking driven by artificial funding gain.

Conclusions

It is important that the regulatory authorities review the internal funding structure in place at the banks they supervise. An artificially low funding rate can create as much potentially unmanageable risk exposure as an inadequate liquidity management regime. A regulatory requirement to impose a realistic internal funding arrangement will mitigate this risk. We recommend the following approach:

A spread over the internal transfer price, based on the median credit risk of the individual business line. This would be analogous to the way the Sharpe ratio is used to adjust returns based on relative volatility. It would also allow for the different risk-reward profiles of different asset classes.

A fixed add-on spread for term loans or assets over a certain maturity, say two years, where the coupon re-fix is frequent (such as weekly or monthly), to compensate for the liquidity mismatch. The spread can be in a sliding scale for longer-term assets.

Internal funding discipline is as pertinent to bank risk management as capital buffers and effective liquidity management discipline. As banks adjust to the cost of compliance with the new liquidity requirements soon to be imposed by the FSA, it is worth them looking beyond the literal scope of the new supervisory fiat to consider the internal determinants of an efficient, cost effective funding regime. In this way they can move towards the heart of this proposition, which is to embed true funding cost into business-line decision-making.

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Dr Moorad Choudhry is Head of Treasury at Europe Arab Bank, and author of Bank Asset and Liability Management, published

by John Wiley & Sons (Asia) Pte Limited