Risk Management in Banking (B-505) Presented By Shah Mohammad Mohiuddin ID#12-038

Chapter -26 FTP Systems

Introduction
Two main tools for integrating global risk management with Decision-making. Funds Transfer Pricing (FTP) system Capital allocation system.
FTP

serves to allocate interest income Capital allocation system serves to allocate risks

FTP Systems addresses Three major issues for commercial banking

The

goals of the transfer pricing system The transfer of funds across business units and with the ALM units The measurement of performance given the transfer price

FTP system specifications

Transferring funds between units. Setting target profitability for business units. Transferring interest rate risk, which is beyond the control of business units, to ALM.ALM missions are to maintain interest rate risk within limits. Pricing funds to business units with economic benchmarks, using economic transfer prices. Eventually combining economic prices with commercial incentives.

GOALS OF THE TRANSFER PRICING SYSTEM

Allocate

funds within the banks Calculate the performance margins of a transaction Define economic benchmarks for pricing and performance measurement Define pricing policies Transfer liquidity and interest rate risk to the ALM unit

Funds Transfer Pricing system and its applications

INTERNAL MANAGEMENT OF FUNDS AND NETTING

Internal

Pools of Funds

Netting:

 Pricing

all Outstanding Balances

MEASURING PERFORMANCE

The FTP System and margin calculations

The Accounting Margin: Example

Given, Transfer Price = 9.20%

Direct calculation of the accounting margin

2000 12% 1200 6% 800 9% = 96

ALM Profitability and Risks

Cost center:
If its target profit is set to zero. responsibility is to minimize the cost of funding hedge the bank against interest rate risk. This cost saving is its Profit and Loss (P&L).

Profit center:
Has a target profit. Optimize the funding policy within specified limits on gaps, earnings volatility or Value at Risk (VaR). Liquidity and interest rate risks should actually be under ALM control. commercial margins should not have any exposure to interest rate risk

RATIONALE OF TRANSFER PRICES

Financial standpoint:

Transfer prices should reflect market conditions

Commercial standpoint: Customer prices should follow business policy guidelines subject to constraints from competition.

Mispricing: Mispricing is the difference between economic prices and effective pricing. Mispricing is not an error since it is business-driven. Nevertheless, it deserves monitoring for profitability and business management. Monitoring mispricing implies keeping track of target prices and effective prices, to report any discrepancy between the two.

Chapter -27

Economic Transfer Prices

Economic Transfer Pricing

Arbitrage opportunities between bank rates & market rates whenever discrepancies appear

Economic Benchmark derive from market price

Economic Benchmark for transfer prices all-in cost of funds, which is applied to lending activates

Commercial Margin & Maturity spread

Spread

means difference between lending long & borrowing short Commercial margin contributes to the accounting margin & under the control of ALM Bank can borrow the money on the market & have a positive margin whatever the maturity

Pricing Schemes

Lending Activities
Risk based pricing is the benchmark & should be purely economic. It implies two basic elements Cost of funds Mark-up

Pricing Schemes (contd.)

Commercial pricing refers to markups & mark-down over economic benchmark to drive the business policies To get the economic transfer price other economic cost should be added-up

Transaction vs. Client Revenues & Pricing

Bank provides products & services & obtain interest spread & fees as compensation

Client revenue is the relevant measure for calculating profitability

The cost of funds for loans

The cost of existing resources

Volumes of assets & resources of a given category(Long term, short term) should be matched For the business unit, any deficit needs matching resources of other business unit. The collection of cheap resources should rather increase the profitability of the unit getting Any cheap resource, such as deposits, subsidizes the profitability of assets. Matching a long-term loan with the core fraction of demand deposits might be acceptable in terms of maturity

The cost of funds for loans

The

Notional Funding of Assets:

Outstanding balance

It does not depend on the existing resources It serves as a benchmark for determining the cost of funds backing any given asset Outstanding balance varies over time until maturity where the market rate of this maturity is not adequate & it would assume that the loan does not amortize over time

40

Debt Spot 1 year Debt Spot 2 year

60

1 Year

2 Year

The cost of funds for loans

The Benefits of Notional Funding

The margin of the asset is immune to interest rate movements There is no need for conventions to assign existing resources to usages of funds There is no transfer of income generated by collecting resources to the income of lending activities The calculation of a transfer price is mechanical & easy

Benchmarks For Excess Resources

Under a global view, the bank considers global management of both loan and investment portfolios

The management of invested funds integrates with ALM policy

Chapter 51
Capital Allocation & Risk Contributions

Risk Contributions are two kinds: risk contributions (ARC) Marginal risk contributions (MRC)
ARCCapital allocation MRCPricing purpose
Absolute

Capital Allocation Goals

The goals of capital allocation :

Aims at allocating both credit and market risk to the business units and the transactions that originate them To provide the top-down and bottom-up links between the postdiversification risk of the bank and individual transactions Risk contributions of facilities to the overall portfolio risk. Allows to break down and aggregate risk contributions according to any criteria as long as individual transaction risk contributions are available

DEFINITIONS AND NOTATION

DEFINITIONS
The standalone risk is the loss volatility of a single facility Marginal risk contribution is the change in portfolio loss volatility when adding a facility f to portfolio p Absolute risk contribution of an existing facility i to portfolio p is the covariance of the random loss of this single facility i with the random loss aggregated over the entire portfolio (including i), divided by the loss volatility of this aggregated loss.

DEFINITIONS AND NOTATION (Contd.) NOTATION:

For the single facility i, the loss is Li . The exposures are Xi , i = 1 to N. Li , i = 1 to N. Exposures are certain and identical to losses given default. To make random losses distinct from certain exposures, we use Li for losses and Xi for exposures a random variable describing the credit state of the facility di

Properties of Risk Contributions

The absolute risk contributions serve to allocate capital. Marginal risk contributions serve to make incremental decisions Absolute risk contributions: To make ex post allocations of capital based on effective usage of line Marginal risk contributions: To make ex ante riskbased pricing decisions.

 Definition of ARCs to Volatility:

This formula defines the absolute risk contribution to portfolio volatility, ARCP:

Simplified Formulas for Risk Contributions:

The two main formulas of absolute risk contributions to portfolio volatility are either in terms of the correlation of in visual losses with aggregated losses or in terms of the i coefficient, which is the coefficient of the relation between individual losses and the portfolio loss:

The Capital Allocation Model & ARCs

Risk Contributions Capture Correlation Effects:

Risk contributions combine the correlation effect with the portfolio and the magnitude of the standalone risk. These risk contributions sum to the loss volatility, not the capital:

From Absolute Risk Contributions to Capital Allocation:

In order to proceed to capital allocation, we need the multiple of loss volatility providing the capital at a given confidence level. To obtain the capital allocations, we need to multiply the risk contributions by a multiple m(),

The Capital Allocation Model & ARCs (Contd.)

From Absolute Risk Contributions to Capital Allocation:

In order to proceed to capital allocation, we need the multiple of loss volatility providing the capital at a given confidence level. To obtain the capital allocations, we need to multiply the risk contributions by a multiple m(),
Absolute risk contributions to portfolio loss volatility and capital allocation:

Chapter 52
Marginal Risk Contributions

General Properties of Marginal Risk Contributions

MRC to the portfolio risk volatility < ARC.MRC< standalone loss volatilities

MRC to portfolio loss volatility add up to a value < the portfolio loss volatility

MRC to portfolio capital can be higher or lower than ARC to capital

MRC to Volatility Vs. ARC to Volatility

Size of Portfolio

With small portfolio no mechanical link between the two. With Large portfolio, the ARC to volatility & to capital might proxy MRC.

Calculation

To calculate ARC is the function of KMV portfolio Manager Credit Metrics calculates the MRC.

Relationship between MRC & ARC:

MRC Vs. ARC for a New facility

Marginal risk contribution MRC f of facility f is lower than the absolute risk contribution of the facility f, ARC P+f

Implication of relationship between MRC & ARC

When

the additional facility is small, chances are that the gap between the MRC & ARC to loss volatility gets small. Capital allocation & risk based performance using ARC cant be equivalent to using MRC. When we add a facility to an existing portfolio, we have two effects.
If ARC

of new facility is positive, increases portfolio risk volatility & vice-versa.

Marginal Risk Contributions & Pricing

The goal of risk-based pricing is to ensure a minimum target return on capital

A required rate serves as a benchmark for risk-Based Pricing

Shareholders Value added refers to the target rate of return on existing equity or Economic Capital

Capital Allocation View Vs. Pricing View:

The

implication of both risk contributions are used for different purposes. Absolute risk contributions are ex post measures. They measure risk contributions for a given set of facilities. Therefore, absolute risk contributions serve to allocate capital for an existing portfolio. Marginal risk contributions are ex ante measures and serve for risk-based pricing.

Ex-Ante & Ex-Post View of Risk & Return:

Risk-Adjusted performance Vs. Risk Based Pricing

The

distinction between the ex ante measure of risk required to meet a target return on capital. The ex post risk-based performances using absolute risk contributions remain necessary for comparing ex post the riskreturn prole. Without risk-based pricing, we do not know the required revenues. Without ex post risk-adjusted performances based on absolute risk contributions, we cannot compare the risk return prole of sub-portfolios.