Why Funds Transfer Pricing (FTP) is Essential to ...

PowerPoint PresentationWhy Funds Transfer Pricing (FTP) is Essential to Meaningful Risk and Profitability Analysis
13-15 May 2019, Santiago, Chile
David Green, PhD, CFA, Workshop Leader
Funds Transfer Pricing Workshop
Workshop Highlights
• Risk and profitability must be modeled consistently if earnings are to be fully understood through the entirety of the rate cycle
• Meaningful margin and ROE calculations are reliant upon well- calculated FTP rates
• The Mismatch Center is an important management unit that must be managed as rigorously as any other business segment
• Lending and deposit gathering business segments are the primary beneficiaries of FTP because of earnings stabilization
• FTP clarifies ALCO’s accountability for IRR-and LR-related earnings
• The practice of FTP is still in its infancy; knowledge is sparse, bad practices proliferate, systems limitations are not unusual and substantive regulatory guidance has yet to evolve
Copyright © 2019 david green advisors 2
• Introduction to Asset/Liability Management
• FTP Theory / Mathematical Explanation o What is FTP and why it is important
o The alignment of risk and profitability management
• FTP Theory / Graphical Exposition o FTP methodologies cannot be arbitrary; they must work in a particular way
o Business units are the primary beneficiaries of FTP; it stabilizes their earnings
o ALCO’s accountability for IRR and LR is enhanced
• FTP Practice / Sample Transaction Analysis
• Challenges / Opportunities for Improvement / Regulatory View
• Workshop Summary
What is Asset/Liability Management and Market Risk?
Asset/Liability Management (ALM) is the practice of managing the risks to earnings and equity that arise from mismatches between various characteristics of the assets and liabilities on a bank balance sheet.
The mismatches with which we are concerned are the differences between the repricing and maturity terms of assets and liabilities:
Repricing mismatches create interest rate risk (IRR) and
Maturity mismatches create liquidity risk (LR).
We will see that these risks complicate earnings and equity management not only at a bank level, but also at a business unit and product level.
Theme: Risk and Profitability must be managed simultaneously.
History of Asset/Liability Management
Over the last several decades, the practice of ALM has been expanded to encompass numerous facets of risk and balance sheet management:
Following the S&L crisis in the 1980s, the initial focus of ALM was on IRR, but the scope was expanded as daily and transactional cash flows could be modeled for the entirety of the balance sheet and events of the late 1990s and early 2000s raised awareness of the need to quantify LR.
In Asset/Liability Management Committee (ALCO) meetings, discussions of strategy, capital and profitability have highlighted the need to extend and align supporting models and analytical processes, e.g. FTP and ROE.
Most recently, balance sheet stress testing has motivated the integration of credit-related factors into comprehensive models of the balance sheet and income statement.
Overnight Rates – Long Term
The US has had challenges with high interest rates in the past; the oil crisis in the late 1970s gave rise to double-digit inflation. Combined with depression-era restrictions on bank deposit rates, the dramatic rise in interest rates caused a major banking crisis in the 1980s. Despite subsequent economic volatility, inflation and rates have trended lower.
see slide 8
see slide 9
The Last Rate Cycle
The last time ALM & FTP managers in the US were really challenged was from 1999-2006: After the dot-com bubble burst, overnight rates fell 500 bps; with the subsequent run-up in housing prices, they were increased by 425 bps. The relationship between risk and profitability was revealed, but could only be seen through a well-functioning FTP process.
Overnight Rates –The Current Cycle
At the onset of the 2007-9 financial crisis, central banks dropped short term interest rates to the lowest levels in history. The FRB and CBC did not increase rates until Dec 2015, but they have only come back up 225 bps. While this has provided some relief for depositories, the pressure on deposit rates will challenge the continued expansion of margins.
< For over seven years, o/n interest rates did not move > < For seven years, interest rates have barely moved >
Interest Rates - Chile
Following a period of high interest rates in the late 1990s, short term rates have trended steadily lower.
Liquidity Spreads – Corporate Debt
Prior to the financial crisis, corporations could issue debt with very low spreads, and many banks could actually issue debt with negative liquidity spreads (see next chart), but when the price of liquidity increased rapidly during the crisis, many firms were not able to manage the change in the price of liquidity effectively, e.g. GE Capital, Wachovia, BearStearns.
Liquidity Spreads – Bank Debt (AA)
— 5 yr Treasury rate
— 5 yr swap rate
Liquidity Spreads – Bank Debt
— 5 yr Treasury rate
— 5 yr swap rate
Basis Spreads
Basis spread volatility is another recent phenomenon that complicates the calculation of FTP rates. Standard (3-month) swap rates need to be adjusted to a preferred hedging point (in this case, overnight).
-3.00%
-2.50%
-2.00%
-1.50%
-1.00%
-0.50%
0.00%
0.50%
Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18
Basis Swap Spreads
3 Month - Overnight Basis Swap - 3 Month Tenor 3 Month - Overnight Basis Swap - 5 year tenor
Net Interest Margin History
Since the early 1990s, bank NIMs in the US have shown a steady deterioration.
What might have caused this?
Net Interest Margin History
Since the early 1990s, even though short term interest rates have moved up and down, longer term interest rates have trended steadily downward as inflation waned and the Fed has purchased a significant amount of term debt. This flattening of the yield curve is yet another form of IRR that must be acknowledged.
Perspectives on ALM
The are two perspectives on ALM, both of which are valid and useful:
• Market Risk/Value at Risk/DV01
• Earnings at Risk/Earnings Sensitivity
Market Risk
The market risk perspective is predominate at investment banks and banks with large trading portfolios. Positions are marked to market. Portfolio managers have historically been given discretion to take credit, IRR and even LR. Market prices reveal information about the price of risk.
Earnings at Risk
The earnings at risk perspective is predominate at commercial banks which derive material earnings through their net interest margin (NIM). While market risk is relevant, the risk to accounting earnings is the primary concern. Book values do not generally contain information about the price of credit, IRR and LR.
Why is ALM Difficult to Do Well?
GAAP/IFRS financial statements represent a naïve view of the world: the balance sheet is shown at historical cost and the P&L does not disaggregate the returns to taking IRR, LR or credit risk. To analyze risk, you need a well-endowed ALM model.
Balance Sheet
Cash Savings
AFS Securities
Investment Securities ST Debt
Commercial Loans
Total Loans
Total Liabilities
Income Statement
( NIM (%) = NII / Average Earning Assets )
Non-Interest Income
Non-Interest Expense
Provision Expense
• Data and Assumptions
o Every loan
o Every debt and capital instrument
o New business
• Computational Engine
o Scenario generator (shocks, ramps, twists, economic scenarios)
• Output
What All Can (Should) Be Done With the ALM Model?
A comprehensive and well-built ALM Model can support the following:
• IRR: Repricing GAP
• IRR: Economic Value of Equity or Market Value sensitivity
• LR: Gap, LCR, NSFR, NCCF and Contingent Liquidity Risk
• Credit and Liquidity Stress Testing
• Budgeting and Forecasting
• Back-testing of earnings and risk projections
• Tactical analysis (pre-purchase analytics)
Sources of IRR
IRR arises from the uncertain re-pricing or maturity of cash flows of individual or groups of balance sheet instruments:
1. Mismatch Risk
• Occurs when assets and liabilities have different re-pricing or maturity terms
2. Yield Curve Risk
• Occurs when the timing of or relationship between cash flows changes as a result of a change in the slope or shape of the yield curve
3. Option Risk
• Occurs when the timing of re-pricing of maturing cash flows changes at the discretion of the bank or its customer
4. Basis Risk
• Occurs when assets and liabilities have different pricing or re-pricing indices; including different currencies
Metrics for Quantifying IRR
IRR is measured through multiple analytical techniques as no single metric is able to capture all of the nuances of the risk exposure: 1. Repricing GAP Report
• Re-pricing schedule of assets and liabilities
• Shows where mismatches exist in the current balance sheet
• Does not capture optionality, yield curve or basis risk
2. Net Interest Margin (NIM) Analysis
• Simulation of future earnings accounting for current positions as well as new business
• Typically static scenarios, but stochastics are possible
• Short term focus (1-2 years); misses long-dated options
3. Duration of Equity (DOE, DV01, Key Rate Durations)
• Estimates rate sensitivity of the economic value of equity
• Ignores the impact on risk of new business
GAP overnight 1-3 months 4-6 months 7-12 months year 2 year 3 year 4 year 5 years 6-10 years 11-30
Securities
Loans
NMA
Assets A0 A1 A2 A3 A4 A5 A6 A7 A8 A9
NMDs
CDs
Debt
NMLs
Liabilities L0 L1 L2 L3 L4 L5 L6 L7 L8 L9
Equity GAP A0 - L0 A1 - L1 A2 - L2 A3 - L3 A4 - L4 A5 - L5 A6 - L6 A7 - L7 A8 - L8 A9 - L9
Key: If A0 - L0 > 0, more assets are re-pricing than liabilities, i.e. asset sensitive
If A0 - L0 < 0, more liabilities are re-pricing than assets, i.e. liability sensitive
In order to accurately quantify the mismatches in each bucket, the expected re-pricing cash flows from every balance sheet line item must be determined.
NMDs are the most difficult to model because they do not have contractual cash flows, yet they can be the most critical line item in the GAP report as they are usually the largest funding source.
Note: equity mismatch is the output.
Measuring IRR – Re-pricing GAP
Prepayment assumptions impact loan and security cash flows, e.g. mortgages
Measuring IRR – NIM Sensitivity
NIM sensitivity is focused on the risk to accounting earnings.
ALCO will have established sensitivity limits and will task Treasury with making sure that these limits are not violated.
Any number of additional static or stochastic scenarios can be analyzed, including shocks, ramps and twists.
Shocks: -200 bps -100 bps BaseCase +100 bps +200 bps
Yr 1 NII $105,000 $102,000 $100,000 $96,000 $89,000
5.00% 2.00% -4.00% -11.00%
Ramps: -200 bps -100 bps BaseCase +100 bps +200 bps
Yr 1 NII $103,000 $101,000 $100,000 $98,000 $94,000
3.00% 1.00% -2.00% -6.00%
Yr 1 NII $425,000 $415,000 $400,000 $380,000 $355,000
6.25% 3.75% -5.00% -11.25%
DOE = ( EVA ∗ DA − EVL ∗ DL ) / EVE
EVE sensitivity (DOE) is focused on the risk to economic value (EV).
While market values can be used for traded instruments, estimates of value (economic value) and potential changes thereto are required for a broad range of non-traded instruments, e.g. whole loans and non- maturity deposits; these can be very subjective.
Term structure models are used to construct the scenarios.
EVE
Measuring IRR – Just What is Duration?
Duration is the most abused term in all of banking! It is not to be confused with the use of the term in the common lexicon in which it refers to the passage of time. WAL is not the same thing.
Duration, within the context of IRR management, refers to price sensitivity – how the price of an instrument or a portfolio changes with regard to a change in interest rates.
Prices and rates generally have a negative correlation, i.e. when interest rates rise, the price falls and vice versa. This relationship is almost never linear; this non-linearity is referred to convexity.
The notion of duration is incredibly important within the context of NMD behaviors; duration is not an innate property. It must be earned.
Caution: When the head of marketing and retail cannot define duration, you don’t have any!
Measuring IRR – Modeling Considerations
• Balance sheet size and composition – constant or dynamic
• New business – business unit or ALM assumptions
• Shocks or ramps
• With or without FTP
• Static or stochastic rates
• If stochastic, calibration requirements/choices
Measuring IRR – Limit Setting
• Is ALCO explicitly responsible for mismatch earnings? If not, who?
• Tradeoff between earnings stability and economic value stability (both cannot be simultaneously zero)
• NII limit setting is straightforward, but the measurement of IRR-related earnings volatility requires a very well-designed FTP process
• EVE limit setting is more nuanced. What is the right target for DOE? Should convexity risk also be limited?
• Capital consumption considerations (see IRRBB)
• Consideration of what will need to happen when limits are violated (board notification, hedging, re-balancing, adjustments to FTP)
Sources of LR
LR arises from the uncertain maturity or timing of cash flows of individual or groups of balance sheet instruments:
1. Mismatch Risk
• Occurs when assets and liabilities have different maturity or cash flow timing terms
2. Option Risk
• Occurs when the timing of or relationship between cash flows changes
3. Price Risk
• Occurs when liquidity is available but at prices that are different than expected
4. Contingent Liquidity Risk
• Occurs when unexpected liquidity demands occur, e.g. advances on lines of credit, market failure (securities), collateral calls, changes in collateral haircuts
Measuring LR
Up until the 2008-9 financial crisis, liquidity in the banking system was viewed and treated as if it was always readily available and free! In fact, some banks were actually able to raise unsecured funding at negative spreads to swap rates. As a result, there was no compelling reason to determine how the cost of liquidity should be allocated throughout the bank. This is actually one reason that the crisis was so severe: when the price of liquidity changed, the users of liquidity were oblivious!
The measurement of liquidity risk has been formalized since the financial crisis. The Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are short term and long term liquidity risk measures which compel banks to hold a minimum level of cash and high-quality liquid assets (HQLAs) against a hypothetical systemic and idiosyncratic event.
These ratios are computed using a very detailed set of assumptions around the liquidity attributes of a large variety of loans, investments, deposit and funding types.
Measuring LR – Liquidity Coverage Ratio
In January 2013, Basel issued the full text of the revised Liquidity Coverage Ratio (LCR) requirement. • The liquidity coverage ratio (LCR) requires banks to have sufficient unencumbered
high-quality liquid assets (HQLA) to withstand a 30-day stressed funding scenario that is specified by supervisors.
• LCR = HQLA / Net cash outflows over the next 30 days; must be >=100%
• HQLA consists of several classes of assets with certain restrictions on quantity of specific types (government debt, agency debt, MBS, etc.)
• Trapped liquidity needs to be acknowledged (not a simple aggregation exercise)
• Cash outflows require an analysis of retail deposit structure and segregation into “stable” and “less stable” deposits (3-10% or higher runoff to be assumed in stressed scenarios; some deposits have 50% or 100% runoff assumptions)
Measuring LR – Net Stable Funding Ratio
In October 2014, Basel issued the full text of the revised Net Stable Funding Ratio (NSFR) requirement. • The net stable funding ratio (NSFR) is a longer-term structural ratio designed to
address liquidity mismatches. It compels banks to use stable funding sources, e.g. high quality capital, term and transaction-based retail deposits.
• The measure is intended to support the institution as a going concern for at least one; gets beyond the cliff of 30 days.
• NSFR = A(vailable)SF/R(equired)SF; must be >= 100%
• Risk weights under the standardized approach for credit risk in the Basel capital framework are used to determine loans that can enjoy lower RSF factors.
• The definition of “stable” and “less stable” deposits is the same as in the LCR and the categorization of HQLA in the LCR is used to determine RSF factors.
• The level of the NSFR is very sensitive to the weights assigned to loans and deposits. These have undergone several revisions since the first release, with changes generally beneficial to most banks.
NCCF is an OSFI requirement that supplements LCR and NSFR.
• The net cumulative cash flow (NCCF) is designed to identify gaps between contractual inflows and outflows for various time bands over and up to a 12 month time horizon.
• The NCCF has a much more granular reporting requirement than the LCR and NSFR.
• Compliance is required along three dimensions:
1) Consolidated basis
3) Major foreign currency basis (USD, Euro, GBP)
• Trapped liquidity needs to be acknowledged (not a simple aggregation exercise)
• Detailed NMD run-off assumptions are provided
• Interestingly, credit and liquidity facilities that are irrevocable or conditionally revocable are reported for information purposes but are not used in the calculation of the NCCF surplus or survival horizon.
• IRR: DOE=[(EVA∗DA)−(EVNMD∗DNMD+EVTL∗DTL)]/EVE)
• LR: LCR/NSFR/NCCF = f(liquidity/run-off characteristics of NMDs)
• Profitability: NIMNMD= FTPNMD − CouponNMD
The challenge is that NMDs have no contractual terms; the principal balance is controlled by depositors and the coupon and repricing behavior is set at the discretion of the bank. These dynamics are not static and must be understood simultaneously across multiple contexts.
Non-Maturity Deposit Modeling Requirements
• Duration estimate
• FTP rates
Characteristics of NMDs which must be modeled:
• Rate sensitivity (beta) – how the coupon rate changes with respect to a change in market interest rates; in practice, the response is non-linear, increasing as interest rates rise and liquidity leaves the banking system
• Decay function – how a typical depositor’s balance runs off; IRRBB begins to limit this
• Volatility function – how stable balances are; LCR/NSFR/NCCF requires a constant % haircut; this approach creates a volatile dollar-duration and volatile DOE; should opt for a dynamic
Non-Maturity Deposit Modelling Challenges
Effective deposit modeling is challenged by numerous potential pitfalls:
• Naive Studies: Most quantitative models of deposit behavior are naïve studies which do nothing more than attempt to tell a story that explains the past; they are not forward-looking and risk-aware, i.e. they are not robust to the vagaries of the business cycle and evolving marketplace
• Logical Fallacies: Virtually all institutions are prone to the “All Deposits Are Above Average” Fallacy; belief trumps facts
• Failures of Governance: The math of deposit modeling is not terribly difficult; the challenge comes in establishing and maintaining meaningful assumptions which are used to assess and manage risk and profitability in a consistent manner.
NMD Model Output – Beta
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
Total Product Balance Avg 1 Mo LIBOR Wtd Avg Coupon
17 months
Total Product Balance Avg 1 Mo LIBOR Wtd Avg Coupon
17 months Regular Savings
2,000,000
4,000,000
6,000,000
8,000,000
10,000,000
12,000,000
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103 109 115 121 127 133 139
Decay Function Estimates (wo/extrapolation)
200,000
400,000
600,000
800,000
1,000,000
1,200,000
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103 109 115 121 127 133 139
Decay Function Estimates (wo/extrapolation)
Regular Savings
Core Balance Estimation
Non-Core (%) Adjusted Balance Fitted Balance Fitted w/Acq Dummies Vol Adj Balance Core Balance Non-Core ($)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Core Balance Estimation
Non-Core (%) Adjusted Balance Fitted Balance Fitted w/Acq Dummies Vol Adj Balance Core Balance Non-Core ($)
NMD Model Output –Volatility
Regular Savings
0
100,000
200,000
300,000
400,000
500,000
600,000
700,000
800,000
900,000
1,000,000
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
FTP Spread Analytics w/ Liquidity Premiums
1 Mo LIBOR 1 Mo Liquidity Premium 10 yr AllIn FTP Rate FTP Spread (%) FTP Rate Coupon Rate FTP Spread ($) FTP Inc Int Exp
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
450,000
500,000
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
FTP Spread Analytics w/o Liquidity Premiums
1 Mo LIBOR 1 Mo Liquidity Premium 10 yr AllIn FTP Rate FTP Spread (%) FTP Rate Coupon Rate FTP Spread ($) FTP Inc Int Exp
Regular Savings w/ LP
Regular Savings w/o LP
Cookies = IRR- and LR-related earnings
There are no cookies to be found in the jar…only crumbs!
The Actual Result of the Typical Bank’s FTP Process
Governance and Accountability For the Mismatch Center is a Corporate Challenge
A well-designed FTP process should identify and transfer IRR and LR to the Mismatch Center. Along with IRR and LR, the earnings associated with these risks are also transferred from the business units to the Mismatch Center. (These earnings are the that belong in the .)
Effective governance and accountability mechanisms are
essential to developing and maintaining a well-functioning FTP process.
The movement of risk and earnings is not a trivial matter. Numerous constituencies throughout the bank have important roles and responsibilities that must be defined and managed within a comprehensive FTP framework. These constituencies are:
FTP ALCO ALM Finance Business Units
Governance and Accountability: Mismatch Center Ownership
One of the primary reasons that FTP does not function well at most organizations is that ownership of the mismatch center is not well-established.
The earnings in the mismatch center are the result of how IRR and LR have been managed.
Consider that IRR and LR must be managed just like credit risk.
If the earnings in the mismatch center do not explain how IRR and LR have been managed, then there is no other metric that allows the committee or persons responsible for IRR and LR to be held accountable.
It is important to recognize that the earnings in the mismatch center are not arbitrarily determined, nor are they residual to the FTP process, nor do they represent a tax on lending and deposit gathering.
The construct of ALCO can make mismatch center management challenging; responsibility may need to be delegated.
FTP Theory Mathematical Explanation
What is FTP?
FTP is an essential business management process for any levered financial institution (Bank, CU or non-chartered FI).
FTP is necessary to reveal the influence risk taking has on corporate, business unit and product profitability.
FTP influences decision-makers across the bank; it drives critical decisions around product pricing, profit attributions, compensation
schema and capital management.
Despite its importance, FTP is not as well-understood as it should be.
Why is FTP Important?
PROFITABILITY
RISK PROFITABILITY$ 5 $ 10
Banks are in the business of maturity transformation.
Maturity transformation creates IRR and LR.
IRR and LR contribute to earnings.
FTP is necessary to reveal how these risks contribute to earnings.
FTP: The Risk Perspective
Borrow
Lend/Invest
FACT: All depositories engage in maturity transformation.
The only point worth debating is the extent to which a particular institution chooses to acknowledge this fact.
“We make $$ on loans and
deposits.”
deposits. We take and
manage IRR and LR.”
deposits and we make $$
and LR.”
1 2 3
Measuring Interest Rate Risk
NIM sensitivity is focused on the risk to aggregate bank earnings.
While ALCO has established sensitivity limits and Treasury/ALM makes sure that these limits are not violated, the limits above do not say anything about where the earnings volatility resides or should reside within the balance sheet; it is possible that the business segments may have considerable risk, but this is not addressed in the analysis of consolidated earnings.
Yr 1 NII $105,000 $102,000 $100,000 $96,000 $89,000
5.00% 2.00% -4.00% -11.00%
Ramps: -200 bps -100 bps BaseCase +100 bps +200 bps
Yr 1 NII $103,000 $101,000 $100,000 $98,000 $94,000
3.00% 1.00% -2.00% -6.00%
FTP: The Profitability Perspective
This is how the typical bank wants to believe that it makes money:
πBank = πLoans + πDeposits + ...
πBank = πLoans + πDeposits + … + πMM
The Mismatch Center is created when FTP is introduced. It is the business unit that contains IRR- and LR-related earnings. These earnings can be positive or negative; zero is possible but is highly unlikely and is
almost certainly inconsistent with the risk profile of the institution.
FTP: The Profitability Perspective
In order to manage a bank with any degree of precision, earnings must be decomposed and managed at a very granular level:
πBank = πLoans + πDeposits + … + πMM
The introduction of the Mismatch Center does not change the level of bank earnings (first order effect), but it does change the distribution of earnings. This recognition could have second order effects, because the
decomposition process will affect subsequent decisions around:
Capital and Resource Allocation
Compensation and Performance Management
constant +/- +/- +/-
Return on Equity
Capital is not free. It is expensive and must be allocated deliberately in order that a sufficient return be provided to shareholders.
Understanding this seemingly simple formula is not trivial:
ROEBank= EarningsBank EquityBank
Not ROEBank= EL∗ROELoans + ED∗ROEDeposits,
but ROEBank= EL∗ROELoans + ED∗ROEDeposits + EMM∗ROEMM
Return on Equity
ROELoans = EarningsLoans EquityLoans
How do we calculate the numerator, the earnings on Loans?
EarningsLoans= (YieldLoans − FTPLoans) − (overhead + taxes + …)
If IRR and LR have been removed from each individual loan, the FTP spread on each loan is a constant and the FTP spread on the portfolio should be relatively stable over time, hence ROELoans will be stable.
FTP Spread
FTP Spread (Loan) = Customer Rate - FTP Rate
The FTP spread should be interpreted as the credit spread, i.e. the return to taking credit risk (IRR and LR have been removed).
If FTP is not computed correctly (intentionally or otherwise), what is understood to be the credit spread will not be correct. Because the return on
(credit) capital will not have been computed correctly, product pricing and capital allocation decisions will be ill-informed.
The FTP spread is similar to a gross margin. Expected (or realized) losses, origination or service fees, overhead costs and taxes must be
subtracted to get to a net margin.
To the extent that capital or the Loan/Deposit ratio is constrained, strategic decisions must be made about where to allocate marginal
dollars. These decisions may be informed by a multiplicity of factors, but one factor should be profitability.
Risk and Profitability Equations Must be Solved Simultaneously
1) π : πBank = πLoans + πDeposits + πMM
2) IRR: ∂πBank
∂πMM ∂l
Equation 1 cannot be solved without consideration of equations 2 and 3:
The level of earnings, whether in the bank or in a business unit, cannot be known (with any confidence) without also knowing how these earnings will change when interest rates and the cost of liquidity change.
what usually gets analyzed
what usually gets analyzed
∂πBank ∂r
= ∂πMM
∂l
These equations cannot be assumed to hold; they must be frequently tested else the source(s) of bank earnings volatility may not be clear.
0 0
0 0
FTP Considerations – Banking Book versus Wholesale Book
In the traditional banking book, lenders and deposit gatherers do not have a mandate to manage their own IRR and LR.
Within the wholesale book, trading portfolio managers generally manage their own market risks.
In the former case, FTP needs to quantify both IRR and LR and move these risks from the business unit to the mismatch center.
In the latter case, FTP needs to quantify only the LR and unhedged IRR (if any) and move the risk from the desk to the mismatch center.
In both bases, contingent liquidity is a challenge that banks are now being challenged to address. Examples include:
• Draws on lending commitments, e.g. credit cards, LOC, BA, etc.
• Run-off of demand deposits or term deposits following a downgrade event
• Collateral implications due to an idiosyncratic shock
FTP Theory Graphical Exposition
Earnings Decomposition in a Bank with no IRR: Perfectly-functioning FTP
Rates
πBank (IRR-free)
Dn 100 bps BaseCase Up 100 bps Up 200 bps Up 300 bps Up 400 bps Up 500 bps
πMM - MM earnings are zero in all scenarios as there are no
IRR-related earnings
No IRR means Bank earnings do not vary as market
interest rates change; nor do business unit earnings
Profit Allocation: π Bank
Earnings Decomposition in a Liability-sensitive Bank: Perfectly-functioning FTP
Rates Dn 100 bps BaseCase Up 100 bps Up 200 bps Up 300 bps Up 400 bps Up 500 bps
πMM - MM earnings are liability sensitive and negative for a
rate shock of Up500
results from the shift to a liability-sensitive position
πMM - MM earnings are liability sensitive and positive in
the BaseCase
πMM - MM earnings are asset sensitive
and negative in the BaseCase
A decrease in earnings in the BaseCase (red bracket)
results from the shift to an asset-sensitive position
`
The business units experience a decline (increase) in
earnings when interest rates increase (decrease)
The decrease in bank earnings associated with being
liability-sensitive is not borne entirely by the
Mismatch Center
πMM
than bank earnings
BU earnings are completely destabilized: ALCO has bet
against an increase in interest rates, but when interest
rates increase, the business units bear the loss and even go
so far as to pay the Mismatch Center for the favor
As rates increase, the decrease in bank earnings is
coupled with in an increase in earnings for the Mismatch
Center
πMM - MM earnings are negatively correlated to IRR
FTP Practice Balance Sheet Example
Sample Bank – Financial Statements
Balance Sheet
non-prepayable
Liability
non-redeemable
Equity*
$10
*Equity is the shareholder’s capital; it is simply the difference between the book value of assets and the book value of liabilities (accounting measures).
Equity has no term or repricing characteristics; this means that it has no inherent duration.
It is important to remember this as we develop measures of IRR and determine FTP rates. There is a tendency to attribute characteristics to equity that are unwarranted. Such attributions will necessarily skew IRR measures and distort FTP prices.
Income Statement
3) Spread = YieldLoan − YieldDep
We are going to use the spread as an approximation for the
bank’s margin to simplify the math:
NIMB = 10% - 3% = 7%
Notice that the repricing term of the loan and the repricing
term of the deposit are different.
While the rate on the loan is fixed for five years, the rate on
the deposit is only fixed for one year. When the deposit
comes due, the rate will reset to market rates which are in
effect at that time.
This timing difference between the repricing terms creates a
risk to earnings and a risk to the value of equity.
Sample Bank – Interest Rate Risk
Repricing GAP
Year 1 7% 7% 7% 7% 7%
Year 2 9% 8% 7% 6% 5%
The risk in the balance sheet is not apparent until Year 2, after the 1 year deposit must be renewed.
Duration of Equity (DOE)
EVA = market value of assets
DA = duration of assets
DL = duration of liabilities
EVE = market value of equity
We will use book values and maturity terms as proxies for
market values and durations. (Caution: This is not a safe or
acceptable practice in general.)
(the equivalent of a 41 year zero-coupon bond)
All three measures indicate that the bank is very liability
sensitive. Each of these measures tells us something about
the risk to equity or risk to return on equity. The risk
derives entirely from the characteristics of the assets and
liabilities on the balance sheet. We have not imputed any
term or repricing characteristics to the equity of the bank.
Sample Bank – Profitability (Pre-FTP)
Margin Allocation
How can the bank allocate the Year 1 margin, NIMB, to its
two business lines?
NIMB = NIML + NIMD
Alternative 1: 7% = 7% + 0% (loan only)
The deposit gather is going to feel cheated because he gets
no credit for generated earnings.
Alternative 2: 7% = 0% + 7% (deposit only)
The lender is going to feel cheated because she gets no
credit for generated earnings.
Alternative 3: 7% = 3.5% + 3.5% (both equally)
Both business units might be happy, but this will not last for
long.
interest rates change?
Year 1 7% 7% 7% 7% 7%
Year 2 9% 8% 7% 6% 5%
While earnings are constant across all rate scenarios in Year
1, the earnings in Year 2 will vary depending on the level of
interest rates. For example, in the Up100 scenario, earnings
decline from 7% to 6%.
How can the bank allocate the Year 2 margin, NIMB, to its
two business lines?
Some combination of the two business units must absorb the
decline in bank earnings:
NIMB = 10% - 3 % = 7%
Alternative 3: 7% = 3.5% + 3.5% (equally both)
Alternatives 1 and 2 left either the lender or the deposit
gatherer feeling cheated.
Alternative 3 seemed to make the most sense, but let’s see
what happens inYear 2.
NIMB = 10% - 4 % = 6%
Alternative 3: 6% = 3% + 3% (equally both)
If we choose Alternative 1, the deposit gatherer is still going
to feel cheated, but now the lender is also going to feel
cheated because her allocation has declined even though she
delivered the same amount of yield to the bank in Year 2 as she
did inYear 1.
If we choose Alternative 2, the lender is still going to feel
cheated, but now the deposit gather is also going to feel
cheated because his allocation has declined even though he
delivered funding at the same spread in Year 2 as he did in Year
1.
Alternative 3 (Yr 1): 7% = 3.5% + 3.5%
Alternative 3 (Yr 2): 6% = 3.0% + 3.0%
If we choose Alternative 3, the lender and deposit gatherer
are both going to feel cheated:
The lender is going to feel cheated because her
allocation has declined even though she delivered the
same yield inYear 2 as she did inYear 1.
The deposit gather is going to feel cheated because
his allocation has declined even though he delivered
funding at the same spread to the market in Year 2 as he
did inYear 1.
Some combination of the two business units must absorb the
decline in bank earnings.
If the bank has IRR, the business units have IRR.
This means that business unit earnings can change for
reasons over which the business units have no control.
The business units will not be able to forecast their earnings
with any certainty; any expectations they might have could
be thwarted by a difference between forecasted and realized
interest rates.
If they are rational, the business units should not agree to be
held accountable to budget targets developed in such a
manner. Success or failure, and hence, rewards and
punishments, will be a matter of luck.
In general, when dealing with n business units, any scheme
for allocating earnings into n-buckets will ultimately not be
satisfactory to the business units.
IRR: Bank and Business Unit Earnings
What is your opinion of how the Sample Bank makes $$?
A bank can usually be characterized by one of the following designations:
• Naïve Bank - “We make $$ on loans and deposits.”
• Typical Bank - “We make $$ on loans and deposits. We take and manage IRR and LR.”
• Smart Bank - “We make $$ on loans and deposits and we make $$ by taking and managing IRR and LR.”
You can probably guess that the Sample Bank earnings have something to do with lending and deposit gathering, but is that all there is?
We saw that Sample Bank clearly has IRR. The question of how a bank earns $$ comes down to whether or not the IRR has anything to do with the level of earnings.
IRR: Bank and Business Unit Earnings
As you might have guessed, IRR does have something to do with the level of earnings. (You must work at the Smart Bank.)
We have not yet developed the tools and processes to quantify how IRR contributes to earnings, but we will begin developing them next.
We are first going to require a funding (transfer pricing) curve: A funding curve is a yield curve which indicates the bank’s estimated unsecured wholesale funding cost for a variety of funding terms. This curve will be used to establish the absolute and relative contribution to earnings of financial instruments which contribute to net interest income.
The details of curve construction are not trivial. At this point, we just need to postulate a curve, but suffice it to say that a detailed process has been established to estimate this curve every day.
Using the FTP Curve to Calculate Funding Rates
We will use the FTP curve to:
• Calculate the funding rate (charge) for the loan
• Calculate the funding rate (credit) for the deposit
To do this, we need to match the term of the (re-pricing) cash flows of these instruments to the appropriate point on the funding curve:
For the loan, we are estimating what it costs to fund the principal balance for the time it is outstanding. The $100 loan on Sample Bank’s balance sheet is a 5-year fixed-rate bullet, so we need to fund the full balance for five years.
For the deposit, we are estimating the funding value of the principal balance for the time it is outstanding. The $90 deposit on Sample Bank’s balance sheet is a 1-year fixed-rate bullet, so we need to credit the full balance for one year.
Using the FTP Curve to Calculate Funding Rates
For the 5-year loan, the funding rate is 7.0%.
For the 1-year deposit, the funding rate is 5.0%.
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
11.0
0 1 2 3 4 5 6 7 8 9 10
Rate (%)
We will now use the FTP rates to:
• Calculate the margin on the loan
• Calculate the margin on the deposit
The margin is the instrument-level spread on a match funded basis.
For the loan, we subtract the funding cost from the loan yield:
NIML = YieldL − FTPL
For the deposit, we subtract the yield from the funding cost:
NIMD = FTPD − YieldD
For the 5-year loan, the spread is 10% - 7% = 3%.
For the 1-year deposit, the spread is 5% - 3% = 2%.
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
11.0
0 1 2 3 4 5 6 7 8 9 10
Rate (%)
Now that Sample Bank is using a funding curve, how can it allocate the Year 1 margin, NIMB, to its two business lines?
NIMB = NIML + NIMD
7% = ? + ?
The spread on the loan is 3% and the spread on the deposit is 2%, so the allocation is:
7% = 3% + 2%
But this equation does not hold. The right hand side is short by 2%. If the spreads allocated to the business units are correct, in order to hold, the equation must read as follows:
7% = 3% + 2% + 2%
X
We have just discovered that the introduction of FTP results in a new bucket into which a portion of the bank’s earnings accrue. This bucket is called the Mismatch Center.
So, what does the mismatch center do and what does the 2% spread in it represent?
In the next few slides, we’ll address these questions. For now, we’ll just note that the 2% is calculated as follows:
NIMMM = FTPL − FTPD
2% = 7% - 5%
The funding charge for the loan represents income to the mismatch center while the funding credit for the deposit represents an expense to the mismatch. The net is the earnings accruing to the mismatch center.
FTP Benefits the Lending and Deposit Gathering Business Units
When a bank utilizes FTP to manage risk and profitability, the primary beneficiaries are the lending and deposit gathering business units.
A key purpose of FTP is to insulate the lending and deposit gathering business units from IRR and LR.
When an FTP rate is properly calculated on a financial instrument, the margin on that instrument will not change over its life.
This is valuable for the business units as they are not otherwise able to mitigate their exposure to changes in market interest rates and the price of liquidity.
FTP Benefits the Lending and Deposit Gathering Business Units
We saw in the previous module that if a bank does not utilize FTP, business unit earnings are exposed to IRR and LR just as the bank is exposed to IRR and LR; they cannot escape it.
By eliminating IRR and LR from business unit and product margins, their earnings become much more stable through the business cycle. Changes in interest rates and changes in the price of liquidity will not cause the margin to change.
When FTP is well-constructed, forecasting and ex-post reconciliations of earnings are much simpler and more meaningful because the impact of changes in market interest rates and liquidity spreads are no longer factors with which business units have to contend.
Sample Bank – Profitability (Post-FTP)
Earnings Deconstruction
Loan
Deposit
Mismatch
Year 1 2% 2% 2% 2% 2%
Year 2 4% 3% 2% 1% 0%
Business unit earnings are constant in all scenarios; they have been immunized from the impact of a change in market interest rates.
This earnings deconstruction demonstrates how FTP is
supposed to work.
If the bank has a well-functioning FTP process in place,
business unit performance should be unaffected by changes
in market interest rates.
Just as the ALM model is used to run numerous rate
scenarios to determine the bank’s exposure to IRR, the FTP
model should be run across numerous pro forma scenarios
to demonstrate that FTP methodologies have effectively
eliminated IRR and LR from the business units.
FTP methodologies should be thoroughly analyzed for
effectiveness prior to being put into production. The FTP
manager should be able to prove that the methodologies
actually work as they are intended to.
Next, we will see where the IRR and LR go when they are
eliminated from the business units.
FTP: The Fundamental Role of the Mismatch Center
The mismatch center is a management unit that is created when FTP is utilized to manage risk and profitability.
Despite rumors to the contrary, it serves a very important role in risk and profitability management.
The role of the mismatch center is to insulate the lending and deposit gathering business units from IRR and LR by gathering
these risks in the balance sheet into one place.
The mismatch center functions like an insurance company where the FTP rate is the price the business unit pays to be insured against certain sources of earnings volatility. Understanding the notion of risk transfer is key to understanding the purpose of FTP.
FTP: The Fundamental Role of the Mismatch Center
In the last section, earnings were decomposed into a portion which accrues to the lending function, a portion which accrues to the deposit gathering function and a portion which accrues to the mismatch center.
NIMB = NIML + NIMD + NIMMM
We wrapped up the discussion without explaining what the earnings in the mismatch center represent. We now explain these earnings:
The earnings in the mismatch center represent the return to the bank from taking IRR and LR.
Through FTP, all of the IRR and LR end up in the mismatch center. Depending on how interest rates and liquidity spreads evolve, the returns associated with these risks may be positive or negative.
Sample Bank – Profitability (Post-FTP)
Earnings Deconstruction
Loan
Deposit
Mismatch
Year 1 2% 2% 2% 2% 2%
Year 2 4% 3% 2% 1% 0%
We saw previously that business unit earnings have been immunized from the impact of a change in market interest rates.
We see here that the IRR in the balance sheet is borne
entirely by the mismatch center.
Looking closer, we see that:
The bank has no exposure to IRR in Year 1 and
neither does the mismatch center.
The volatility in earnings in Year 2 at the bank level is
identical to the volatility in earnings in Year 2 in the
mismatch center.
In order for business unit earnings to be immunized from
IRR, the risk has to be transferred from them. But, the risk
has to go somewhere within the bank; it doesn’t just vanish.
The IRR ends up in the mismatch center.
Visualizing Interest Rate Risk Transfer
It may help to visualize what risk transfer looks like:
Recall the math of perfectly-functioning FTP: ∂πBank
∂r =
0 0 0
We have not specifically addressed LR, but the same logic holds:
The math of perfectly-functioning FTP holds again: ∂πBank
∂l =
0 0 0
The choice, composition and management of the FTP curve are crucial elements of the framework.
At NBC, the FTP curve is estimated from the market yield of senior, unsecured funding. The FTP curve should not be a blended rate derived from the actual funding mix of the bank, nor should it include any collateralized borrowing. It represents marginal funding/hedging costs.
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
11.0
0 1 2 3 4 5 6 7 8 9 10
Rate (%)
Swap Curve
The components of the FTP curve are derived from the cost (value) of hedging IRR and LR. These costs must be re- estimated every day.
Adjustments are made for non- stable haircuts, collateral value/cost and optionality.
Matched-Maturity FTP Calculations
Once the FTP curve has been established, the re-pricing and liquidity cash flows from each transaction can be used to calculate FTP rates.
The MMFTP rate on the entire balance is the sum of two blended rates, each of which reflects partial MMFTP rates applied to individual cash flows. The following formula is used to calculate the MMFTP rate:
where t is initially the origination date of the transaction and τ is the term point on the repricing cash flow schedule, cash flow schedule, swap curve and liquidity premium curve at time t.
The first term is re-estimated in subsequent periods while the second term is held constant for the life of the transaction.
MMFTP Ratet= σ (Repr Cash Flowτ∗Spot Swap Rateτ∗τ)
σRepr Cash Flowτ∗τ +
σ t=0
Cash Flowτ∗τ
The Funds Transfer Pricing Framework is Complex
FTP is not just a simple computational process that the ALM manager can handle in his spare time. It is an entire framework that must be developed and maintained; it requires the coordinated efforts of numerous individuals and departments across the depository institution.
• Data (detailed transactional records; includes behavioral chars.)
• Behavioral models (optionality; contingent liquidity)
• Simulation engines (forward-looking; multi-scenario; sensitivity)
• Systems (there should be only one; minimize synchronization issues)
• Policies (ALM/FTP; performance management; risk appetite)
• Operating procedures (daily)
• Governance (business units and ALCO must be held responsible)
Regulatory Guidance for FTP (BIS)
2008: Principles for Sound Liquidity Risk Management and Supervision
In the midst of the financial crisis, banks were specifically called out for failing to manage liquidity risk that is inherent in many bank products:
• Banks did not have an adequate framework that satisfactorily accounted for the liquidity risks posed by individual products and business lines, and therefore incentives at the business level were misaligned with the overall risk tolerance of the bank.
• Banks should incorporate liquidity costs, benefits and risks in the internal pricing, performance measurement and new product approval process for all significant business activities.
• [Processes should be in place for] the identification and measurement of the full range of liquidity risks, including contingent liquidity risks.
2010: Guidelines on Liquidity Cost Benefit Allocation
The guidance address several elements to be considered when creating or reviewing adequate liquidity cost benefit allocation mechanisms:
• Include not only direct liquidity costs, but also costs associated with contingent support.
• FTP mechanism should facilitate and reinforce the risk culture around liquidity.
• FTP should link strategic direction with liquidity resource allocation.
• FTP should improve processes for pricing products, measuring performance, assessing new products and enhancing the tools for asset/liability management.
• Aligns risk-taking activities of individual business lines with the liquidity risk exposures their activities create for the institution as a whole.
2016: Interest Rate Risk in the Banking Book, BIS
The guidance, which is expected to be implemented by 2018, is more prescriptive than previous guidance.
• Provides requirements for both EVE (capital) and NII (earnings) sensitivity measurement
• Credit spread risk is addressed, e.g. jump to default cash flow implications
• Prescribed shocks plus additional scenarios, e.g. historical simulation
• Principle 5: In measuring IRRBB, key behavioral and modelling assumptions should be fully understood, conceptually sound and documented. Such assumptions should be rigorously tested and aligned with the bank’s business strategies.
• Monitoring and maintenance requirements (strong enough?)
• Model Risk Management (see OCC 2011-12)
• Public disclosure requirements around process and key assumptions
• Behavioral assumptions around the average life of NMDs are capped
2016: Interagency Guidance on Funds Transfer Pricing Related to Funding and Contingent Liquidity Risks
The guidance makes clear that the SIFIs are expected to:
• Allocate FTP costs and benefits on funding risk and contingent liquidity risk.
• Have a consistent and transparent FTP framework for identifying and allocating FTP costs and benefits on a timely basis and at a sufficiently granular level, commensurate with the firm’s size, complexity, business activities, and overall risk profile.
• Have a robust FTP governance structure including the production of a report on FTP and providing oversight from a senior management group and central management function.
• Align business incentives with risk management and strategic objectives by incorporating FTP costs and benefits into product pricing, business metrics, and new product approval.
Bad Practices Proliferate (Beware Your Peers)
Because regulators have, until recently, been largely silent on the subject of FTP, a broad range of (bad) practices has evolved, many of which distort the perception of risk and miscalculate profitability:
• Equity is assigned a duration (creates free funding)
• FTP rates are calculated based on WAL or duration (ignores curve slope)
• Liquidity premiums are ignored (free money for lenders)
• Liquidity premiums are not updated frequently (anything less than daily)
• Historical and pro forma FTP rates are not computed (insufficient detail)
• FTP spreads are assumed to remain constant in budgets/forecasts (seriously?)
• FTP systems are separate and distinct from ALM systems (irreconcilable)
• The Mismatch Center is not modeled (no acknowledge or risk-related earnings)
• The Mismatch Center is not managed (no accountability for ALCO)
• Mismatch Center earnings are forced to zero by adjustments to FTP rates or a redistribution of earnings after the fact (keeps earnings volatility in bus. segments)
DGA FTP Survey Results
In early 2018, in conjunction with FMS/AMIfs, David Green Advisors conducted a survey of member banks and credit unions.
Preliminary findings (publication is pending):
• The majority of respondents did not believe that FTP is necessary to explain how a depository institution makes money.
• The majority of respondents did not believe that their institution told a credible story about how it makes money.
• The majority of respondents indicated that they did NOT believe that their management reams understood the purpose of FTP.
• The majority of respondents indicated that they did NOT believe that their primary regulator understands the purpose of FTP.
• Virtually all respondents indicated that the model they rely upon for quantifying deposit behaviors does not speak to FTP.
Workshop Summary
• IRR and LR contribute to earnings and earnings volatility.
• FTP is the process for transferring these risks from the business units to the mismatch center.
• FTP prices should reflect the contemporaneous cost of hedging the IRR and LR (regardless of whether or not it is actually hedged).
• FTP is the business process that should ensure a consistent view of product behaviors across RISK and PROFITABILITY MANAGEMENT disciplines.
• Governance of the mismatch center is critically important to ensuring that FTP is well-functioning.
• Practices and regulatory expectations can be expected to evolve.
The Fight for Mismatch Center Earnings
Is it a fair battle? Should it be? What happens when it’s not? What is the optimal way to ensure that the mismatch is well-defended?
Words of Wisdom
It is difficult to get a man to understand something when his salary depends upon his not understanding it.
- Upton Sinclair
A lot of people in a bank benefit from significant flaws in risk and profitability management processes. These people may feign ignorance, claim that FTP is unnecessary, try to sell management on the myth of a
balanced balance sheet or even go so far as to claim that equity has duration, all in an attempt to justify earnings that do not rightly belong
to them.
- David Green*
* I extend my apologies to Upton Sinclair for putting my words on the same page as his.
About David Green, PhD, CFA
Dr. Green draws on lessons learned in a 20 year career spanning banking, bank regulation, consulting and software development to bear on a broad range of risk and balance sheet management challenges. He has been a consultant for 9 years. Prior to this, he served as the Treasurer at BankUnited, the largest bank headquartered in Florida, where he was responsible for the investment portfolio, funding and derivatives, secondary marketing, FTP and ALM. Before joining BankUnited, he was the A/L Manager at SunTrust Bank where he built and managed all of the static and stochastic interest rate risk models for the bank and worked to coordinate a number of business functions including budgeting/forecasting, funds transfer pricing and strategic balance sheet management.
Dr. Green is a former Chairman of the Georgia Bankers Association's A/L Management Committee. He also served as a Bank Examiner at the Federal Reserve Bank of Atlanta, where he also spent two years in research while completing his Ph.D. He was Chairman of SunGard/Bancware's US Client Advisory Council for many years. Dr. Green holds a Ph.D. in Economics from Georgia State University, a BS in Applied Mathematics from Georgia Tech and is a CFA charter holder.
About David Green Advisors
DGA is a boutique advisory firm led by David Green. Specializing in risk and profitability management, DGA advises in all aspects of framework development, including policies, models, processes and governance structures. A leading provider of risk and profitability workshops around the globe, DGA offers a unique blend of advisory services and education that maximizes knowledge transfer and ensures practical consistency throughout the depository institution.
Areas of Specialization:
• Executive Training
Contact Information

Date post:	28-Mar-2022
Category:	Documents
Upload:	others
View:	2 times
Download:	0 times

Why Funds Transfer Pricing (FTP) is Essential to ...

Documents