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Incorporating Liquidity Risk into Funds Transfer Pricing: Progress

and Challenges

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Incorporating Liquidity Risk into Funds Transfer Pricing:

Progress and Challenges

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Incorporating Liquidity Risk into Funds Transfer Pricing: Progress and Challenges

Arno Kratky - Head of Liquidity Analytics, Group Treasury, CommerzbankKumar Tangri - Risk Specialist, ALM & Liquidity, FSAVijay Krishnaswamy - Partner and Head of Enterprise Risk Management, Hymans Robertson

66

FTP regulations: A clear view on the horizon?

Kumar Tangri

Today’s Agenda

• How are regulations incorporating FTP into liquidity management

• Will FTP play a larger role in future regulation

• Things to look out for

Overriding message

Good Funds Transfer Pricing practice drives sustainable business models.

Messages from Funds Transfer Pricing help develop strategy

9

Funds Transfer Pricing – what is it?

Funds Transfer Pricing (FTP) is the mechanism by which the

cost, benefits and risks of liquidity is reflected to a firm’s business lines – i.e. a sophisticated, forward looking

pricing model.

It is an internal measurement and allocation process that assigns a liquidity risk-adjusted profit contribution value

to funds gathered and lent or invested by the firm.

FTP is one aspect of full Transfer Pricing, which builds hurdle

rates by inclusion of cost of capital (for instance for credit

risk).

How are regulations incorporating FTP into liquidity management

• BIS - Principles for Sound Liquidity Risk Management and Supervision [Sept 2008] {Principle 4}

• FSA – PS09/16, Strengthening Liquidity Standards [October 2009] {BIPRU12.3.15E} {BIPRU12.5.4R}

• EBA – CP36 Guidelines on Liquidity Cost Benefit Allocation [March 2010]

1111


• PS09/16, Strengthening Liquidity Standards {BIPRU12.3.15E}

States that firms should accurately quantify liquidity costs, benefits and risks for– product pricing– performance measurement and incentives– new product approval

Applies to significant business activity – on and off balance sheet

Consider FTP in normal and stressed conditions

Clear and transparent – needs to be understood across the business

1212


• PS09/16, Strengthening Liquidity Standards {BIPRU12.5.4R}

Requires firms to include assessment of compliance with

BIPRU12.3 and BIPRU12.4 (systems and controls requirements)

in the ILAA

Compliance influences ILG

1313

Will FTP play a larger role in future regulation

• Andrew Bailey, Executive Director, Bank of England and Director, UK Banks and Building Societies, FSA - Santander International Banking Conference 2009

“fire prevention is better than fire-fighting. We cannot justify having a

banking system that depends on the use of public money to douse

the fire when the crisis comes. And we also cannot allow conditions

to exist where risks are taken on the basis that this backstop exists.”

– Santander International Banking Conference 2009

1414

Will FTP play a larger role in future regulation

Good Funds Transfer Pricing practice drives sustainable business models.

• Withdrawal of taxpayer support – whether implicit or explicit

• Solo self sufficiency and sustainable business models

• Recovery and Resolution Planning

1515

• FSA Dear Treasurer letter on Funds Transfer Pricing (http://www.fsa.gov.uk/pubs/international/ftp_treasurer_letter.pdf)

• Benefits and pitfallsBenefitsInforms business strategy by identifying the liquidity risk adjusted return

from business activities. It helps prevent firms “sleep walking” into business

where the true cost of funding is not covered.

Contributes to a sustainable business model.

Consequence of poor FTP Misallocation of liquidity resource – like capital, liquidity is scarce and

needs to be used wisely.

Conduct of loss making business or business where reward is not commensurate

with risk.

What do and will regulators expect

Things to look out for

• FTP governance – who owns and challenges the model? Can it be gamed or arbitraged? Is it transparent to stakeholders? Is treasury conflicted?

• What components are charged? Is the cost of liquidity buffer recharged? Are all aspects of liquidity risk accounted for? E.g. intra day liquidity, FSCS costs

• Is FTP accurate? Does it capture marginal costs? Can it be back tested? Are there un-priced risks?

• Approach to back book – does this distort new product pricing?


Things to look out for

• How detailed is FTP? Is it granular enough to influence strategic and day to day transaction decisions? E.g. does it distinguish between asset origination which can be securitised versus assets that can’t?

• Does it incentivise appropriate business line behaviours?

SHOULD ENCOURAGE APPROPRIATE INCENTIVES – TO WRITE AN OPTIMAL BUSINESS MIX

FRAMEWORK SHOULD BE PROPORTIONATE TO FIRMS’ SCALE AND COMPLEXITY - E.g. Frequency with which

pricesare reviewed, frequency of back testing


18

Funds Transfer Pricing – hurdle rate

Funds Transfer Pricing

FTP

Recharge cost of liquidity buffer sized using stress & scenario testing

Cost of intra day liquidity

Cost of funding Reference rate

Cost of funding Term liquidity premium

Maturity transformation

Cost of contingent commitments

Cost of un-hedgeable risk (e.g. basis, prepayment)

Cost of capital – credit risk

Commercial margin

Marginal funding curve

e.g. 3 month Libor

Risk adjusted profit

Hurdle rate

1919

FTP practices – marginal costing


2020

Funds Transfer Pricing – marginal costing

Yield (%)

Time (t)

Marginal cost

Weighted average cost, back book

21


• Pros

– Correctly captures the cost of doing new business

• Cons

Build up of residual unallocated P&L impact due to:

– FTP model not accurately reflecting the actual cost of funding which

might be incurred, e.g. model charges Libor + 150bp as marginal cost,

but actual incurred cost was Libor + 160bp

– management overlay, where a deliberate “subsidy” is embedded in

pricing to incentivise behaviours, e.g. provide 50bp extra credit for

stable retail deposits to incentivise gathering

22


Time (t)

Asset

Liability

FTP model assumptionsFunding cost ≠ FTP model assumptionsFunding tenor ≠ FTP model assumptions

Yield (%)

Time (t)

Asset

Liability

Time (t)

Asset

Liability

Maturity

Maturity

Yield (%)

Yield (%)

Maturity

Incorporating Liquidity Risk into Funds Transfer Pricing: Progress and Challenges

Arno Kratky

Group Treasury PRMIA, London January 18th, 2012

Group Treasury – Liquidity Analytics

PRMIA, London January 18th, 2012

24

Agenda

1. The Regulatory Framework

3. Interplay with Fund Transfer Pricing

4. Implications for bank’s steering framework

2. Interplay with Internal Liquidity Management Framework



25

International standard: Basel III

BCBS 164 / 189

LiquidityLeverage RatioCapital

BCBS 165 / 188

More and better capital• shift focus to core Tier I capital• excluding hybrid capital• deducting deferred tax assets• minority interests not considered• no Tier III component

Higher RWA• introduce credit value

adjustment• account for correlation risk• higher charge on trading books

(stress VaR, incremental risk)• increase counterparty risk

charge(incentivise central counterparts)

Higher capital ratiosCounter-cyclical capital buffers

Introduction of generalleverage ratio• backstop ratio, not risk-based• nominator is balance sheet total

plus (1) off-balance positions, (2) un-netted derivatives, (3) notional of written credit derivatives

• denominator given by regulatory Tier I capital

• broadly in line with IFRS accounting

Liquidity Coverage Ratio LCR• Buffer to be held against short

term liquidity shortages

Net Stable Funding Ratio• effectively limits maturity

transformation

Monitoring tools (information only)

• contractual maturity mismatch• concentration of funding• unencumbered assets• market-based data

Public disclosure

European implementation: CRD 4

The building blocks of Basel III

BCBS 189: Strengthening the resilience of the banking sector; BCBS 188: International framework for liquidity risk measurement, standards and monitoring



26

Understanding the Regulator‘s Perspective of Basel III in a Nutshell

Cash markets are fragile and can disappear quickly

Too much maturity transformation is unhealthy for the financial system

Interconnected financial sectors can collapse like a house of cards

There is good banking business (loans, deposits, service real economy)

There is bad banking business (prop trading, derivatives, casino)



27

Liquidity Coverage Ratio / Liquidity Factors

Impact on different product types on identical balance sheets:

30 one week repo on Government Bond

liabilities

Outflow 0

50 Government Bond

assets

Buffer 201)

LCR 1000%

but

30 3-months IB MM Outflow 0

40 O/N retail (stable) Outflow 2

liabilities

assets

30 O/N IB MM

40 3 months retail (stable)

No credit for short term secured funding of illiquid securities

No credit for short term wholesale (interbank) funding

50 ABS Bond (illiquid) Buffer 0

30 one week repo on ABS Bond

50 Government Bond

50 ABS Bond (illiquid)

Outflow 30

Buffer 50

LCR 83%

Outflow 30

Outflow 0

Buffer 0

1) Only 20 units unencumbered since 30 funded via repo



28

Net Stable Funding Ratio / Liquidity Factors

Demonstration of the impact on different products and trading strategies:

3 Mon. CP non-financial

Liabilities

ASF 50%

Corporate Bond AA

Assets

RSF 20%

NSFR 250%

9 Mon. Repo

Liabilities

ASF 0%

Corporate Bond AA

Assets

RSF 20%

NSFR 0%

Listed Equity

Assets

RSF 50%9-months loan to Hedge Fund

Assets

RSF 0%

6m Reverse Repo on 3y Corp. Bond A+

Assets

RSF 50%3y Corp. Bond A+funded via 6m Repo

Assets

RSF 0%

Unencumbered mortgage loan Basel II KSA 35% >1y (independent on maturity)

Assets

RSF 65%Mortgage loan > 1y in covered pool funded by Covered Bond

RSF 100%

Assets

+ Overcollateralisation for target rating

5y Government Bond RSF 100%2y Reverse Repo on Government BondRSF 5%



29

Liquidity Implications Non-Operational Corporate Deposits

Interplay between LCR and NSFR for non-operational corporate deposits and (short-term) corporate loans (1)

Buying Level 1 assets for the buffer itself generate an additional NSFR requirement

75m Level 1 Asset

100m Non-op. Corporate Deposit

50% => 50m

Assets

100% => 75mBuffer (LCR)

Liabilities

ASF (NSFR)

75% => 75mOutflow (LCR)

Remaining Cash 25m 25m Term Loan 100% => 25mRSF (NSFR)

LCR = 75

75= 100% NSFR =

50

28,75= 174%

Though there is headroom in the NSFR, the bank can not lend more (in cash) due to LCR restriction

5% => 3,75mRSF (NSFR)

=> 100m corporate deposits fund 25m term loans



30

Interplay between LCR and NSFR for non-operational corporate deposits and (short-term) corporate loans (2)

In order to use the NSFR ‘capacity’ the bank has to extend its balance sheet and borrow another 21m > 30days at extra costs, which also may compromise the bank’s liquidity ratio (and bank levy)

75m Level 1 Asset

100m Non-op. Corporate Deposit

50% => 50m

Assets

100% => 75mBuffer (LCR)

Liabilities

ASF (NSFR)


Remaining Cash 25m 46,25m Term Loan

100% => 46,25m

RSF (NSFR)

LCR = 75

75= 100% NSFR =

50

50= 100%

21.25m short term wholesale > 30d


Extra cash 21.25m

Liquidity Implications Non-Operational Corporate Deposits

5% => 3,75m

RSF (NSFR)

=> 100m corporate deposits fund 46,25m term loans



31

Bank B

Equity 5 ASF(100%) 5

Stable Deposits 100 ASF(90%) = 90 LCR outflow (5%) = 5

Cash 5 LCR Buffer (100%) = 5

Retail Loan 100 RSF(85%) = 85

Bank A


Equity 5 ASF(100%) 5

Bank A Bank BLCR > 100% 100%NSFR > 100% 112%

1

Bank B borrowing funds via stable deposits (<1yr) and lending on term to retail customers (<1yr, but no inflows < 30days). Bank A just holds cash.

Inefficient Liquidity Transfer within the Banking System (1/3)

Bank A Bank BBalance Sheet 5 105Buffer 5 5Net Outflows 0 5ASF 5 95RSF 0 85



32

Bank BBank A


Bank B may transfer liquidity within the banking sector to Bank A via a long-term money market loan. Bank A invests the proceeds into the same portfolio of retail loans as before. RSF for Bank’s B loans increases from 85% to 100%, hence it can only lend 95 to Bank A (Bank B holds the balance in cash and hence increases its buffer). Using its cash balance of 5, Bank A can lend 100 to the private sector.

Bank A Bank BLCR > 100% 200%NSFR 118% 100%

2Equity 5 ASF (100%) 5



Loan to FI > 1yr 95 RSF(100%) = 95

Equity 5 ASF (100%) 5

Deposit from FI > 1yr 95 ASF(100%) = 95



Liquidity Transfer of 95




33

Bank BBank A


When the remaining maturity of the liquidity transfer runs below one year, the efficiency of the liquidity allocation gets impaired. Though the external economic position from the banking sector to the private sector remains unchanged, Bank A would now be required to take additional term funding to comply with the NSFR (inflating its balance sheet) passing on additional costs to its clients or has to withdraw its loans to its customers.

Bank A Bank BLCR > 100% 200%NSFR 6% >> 100%

3




Loan to FI < 1yr 95 RSF(100%) = 0


Deposit from FI < 1yr 95 ASF(0%) = 0






34

Basel III – Commerzbank‘s Contribution to the Industry Dialogue

Participation in Industry working groups

Commerzbank plays an active role in liquidity working groups in various banking associations and bilateral discussions with aligned banks as well as with national regulators

Ba

nki

ng

Ass

oci

atio

ns

Alig

ne

d B

an

ks

Regulatory Authorities…and

others…

http://www.bankenverband.de/

http://www.bankenverband.de/

http://www.iif.com/

http://www.afme.eu/

http://www.aci-germany.de/7425--~de~VerticalNavigation~index.html

http://www.deutsche-bank.de/index.htm

http://markets.rbs.de/

http://www.fsa.gov.uk/pages/index.shtml



35

Agenda







36

Increasing Complexity

Regulation is a moving target and subject to substantial changes

Cumulative effects of regulation and associated (unintended) consequences on markets and banks business models are not well understood

Ratios can not be seen in isolation but need to be managed simultaneously as ratios are interlinked. Measures which are positive for one ratio can turn out to have negative outcomes for another

Regulatory (minimum) requirements will become more binding and need to be actively managed

Banks are left with only little flexibility to manage cumulative effects effectively and to manage liquidity efficiently

New regulations lead to alignment of liquidity management frameworks across banks which may result in more rather than less systemic risk



37

Main Differences between Regulatory and Industry Approach

Commerzbank SFR

Industry Approach **)Regulatory Approach *)

Operational Liquidity Management

• Continuous observation period up to 12 months• Representation of cash flow over whole period• Wider definition of liquid assets• Consideration of central bank eligibility• Consideration of interbank funding potential• Decomposition into legal cashflows, behavioural

adjustments and liquidity capacity• Allows for different scenario calculation• Measure expressed as surplus

Commerzbank SFR

Liquidity Coverage Ratio (LCR)

• Observation period 30 days• 30 days point-in-time cumulative cash flow• Narrow definition of liquid assets (no financials)• Focus on secondary market liquidity• No roll-over assumption for interbank funding• Monoblock measure

• Only combined stress scenario• Measure expressed as ratio

Short term

Long Term

Commerzbank SFRNet Stable Funding Ratio (NSFR)

• Severe Stress scenario• Minimum ratio 100% permanent• Assets and liabilities differentiated by type of

customer and relationship• All securities require stable funding (haircut) • Loan business funded as per roll-over fiction• Matched funded structures not considered• Contingent liquidity require stable funding• Covered bonds (self-issued) not considered

as stable funding if remaining maturity < 1 year, covered pool still attracts RSF

Commerzbank SFRStructural Liquidity Management

• Less severe scenario w/o need for CM funding

• Target corridor instead of strict limits• Assets and liabilities differentiated by product

type and business owner • Less liquid securities funded on haircut• Core loan business requires stable funding• Matched funded structures considered• Contingent liquidity considered in stress

portfolio• Covered bonds (self-issued) considered

(partly) as stable funding also if remaining maturity < 1 year.

*) BCBS 188 as of December 2010 **) Observed methodology across firms



38

Does Basel III overrule internal fund transfer pricing ?

Internal treatmentmore conservative than BIII

Internal treatmentconsistent with BIII

Internal treatmentmore aggressive than

BIII

()

• Is internal treatment still competitive ?

• Will change of internal treatment be challenged by supervisor ?

• Only little impact on running business

• The least need for adjustment

• Regulatory liquidity requirement need to be ‘subsidized’ by other products

• Business in danger of being unprofitable

• How to migrate to regulatory compliance ?



39

Does Basel III overrule Internal Funds Transfer Pricing ?

Compliance of external and internal requirements on aggregate level

Basel III

LCR

NSFR

Internal

operational

structural

Steering Independent

Less complex, but steering in case of breaches less efficient



40

Does Basel III overrule Internal Funds Transfer Pricing ?

Compliance of external and internal requirements on product level

External requirements have significant influence but steering mechanism is synchronized

Basel III

Assets

Loans

Deposits

Facilities

others

. . .

Internal

Assets

Loans

Deposits

Facilities

others

. . .



41

Agenda







42

Integrated Steering Framework

Basel III will influence internal processes, but is neither a blue-print for an internal steering system nor for an internal (liquidity) funds transfer price system



43

Does Basel III overrule internal fund transfer pricing ?

Major banks employ a liquidity management system and fund transfer pricing methodology similar to Basel 3 but which differ with regard to parameters. How does a bank cobe with the difference? Working example (asset vs asset):

Corporat

e Loan

Credit

Facility

Options to deal with:

1. Treat Basel III / FTP separately -> two steering mechanism to follow

2. Only adobt induced regulatory ‚minimum‘ requirement -> conservative / expensive but aligned on

product level

100

m

1bn

50m

5%

100

m

50% 100

%

50m

0%

Basel III

NSFR Internal

Requirement

50m 100

m 50m Basel III

NSFR Internal

SF

Ratio met at overall levelbut triggered by different products

Loans -> ‚too expensive‘Facilities -> ‚too cheap‘

Balance Sheet Volume

RSF / internal requirement

3. Adjust FTP towards regulatory framework -> most consistent alignment, abandonment of own economic assessment, could be challenged by regulator



44

How to adopt Basel III to internal fund transfer pricing ?

Banks need to set steering signals to their trading units to manage restructuring of balance sheets. Timing is an important component. How fast should banks implement Basel 3 rules in FTP? Working example: Funding of a financial bond

Options:

1. Keep current FTP and adjust as late as possible -> inappropriate adjustment to

Basel 3

2. Adjust FTP immediately for anticipated B 3 funding costs -> triggering of unintended

consequences?

3. Phase-in higher charges over time and signal to the trading desks -> proportional migration to reg.

environment

Currently, banks fund financials short term as they are tradable in financial markets. However, Basel 3 requires term funding latest by 2018. Banks have to adust their funding accordingly:

Time

FTP(in bps)

2011 2018

FTP(in bps)

2011 2018

FTP(in bps)

2011 2018

1 2 3



45

Agenda







46

Where the Business is affected

Understand mechanics of Basel III and implications on business model

Analyze portfolio mix and identify which products will have different treatment under regulatory rules compared to current internal treatment

Consider potential pricing implications on anchor products (PK: retail loans & deposits, MSB: corporate loan book, C&M: trading portfolio, matched book, equity financing, ABF: secured financing)

Understand need of customers and potential implication for end-users (to facilitate dialog with supervisors)

Monitor competitors and their potential adjustments to product mix and/or pricing behavior

Assess potential to pass on additional costs or anticipate structural changes to product mix

Think about product innovation (but be aware of reputational limitation to exercise optionality)



47

Behavioral Adaption to NSFR

ASF

RSF

NSFR Isolines

= 100%

> 100%

< 100%

Improving NSFR

1

2

To improve a given NSFR (indicated by in the chart above) an institution has two options:

1. The institution can increase the ASF by adjusting the liability side of ist balance sheet (e.g. liabilities with higher roll-over factors or longer duration)

2. The institution can decrease the RSF by adjusting the asset side of ist balance sheet (e.g. assets with lower roll-over factors or shorter duration)

NSFR =ASF

RSF

Potential Adjustments on Business Model• compress net position of derivatives• cut credit lines• focus on advisory business• revival of ‚originate and distribute‘ model

Adjust Asset Side• reduce maturities• shift to assets with

lower RSF

Adjust Liability Side• increase maturities• shift to liabilities with

higher ASF

NSFR

impact onearnings

impact oncosts



48

Potential Steering Measures to Manage the LCR

Hold more Cash

Sell illiquid assets and buy level 1/2 assets

Increase duration of liabilites (e.g. short term deposits)

Liquidity buffer LCR =

(Cash outflow – Cash inflowcap 75%) ≤ 30d

Levers to manage the ratio:

Increase Liquidity buffer(-> higher costs)

Decrease Cash outflow (-> lower returns)

Increase Cash inflow (-> lower returns)

Increase stability of deposits (e.g. stable retail deposits and wholesale operational accounts)

Decrease duration of assets (e.g. short term loans)

Decrease potencial liquidity drains (credit/ liquidity facilities)



49

Potential Steering Measures to Manage the NSFR

Originate new liabilities (and invest cash into assets with lower RSF)

Securitize existing business which is already term funded (and keep existing funding)

Substitute liabilities with short duration (<1y) by liabilities with longer duration (>1yr)

Substitute liabilities with low ASF (wholesale) by liabilities with higher ASF (retail)

Sell (non-level 1/2) assets

Substitute assets with longer duration (>1yr) by assets with shorter duration (<1y)

Substitute assets with high RSF (illiquid bonds, term loans, retail loans) by assets with lower RSF (0%-risk weight govies, short term loans to financial institutions)

New asset business does not improve the ratio

Available Stable Funding (ASF) NSFR =

Required Stable Funding (RSF)

In principle, the bank has two levers to manage the ratio:

Increase ASF (-> higher costs) Decrease RSF (-> lower returns)



50

Regulatory Requirements – More than a Compulsory Excercise

Forthcoming regulation will not allow for an escape clause, allowing institution to apply internal liquidity models for regulatory reporting purposes instead of standardised external rules. Hence, liquidity regulation becomes instantaneous binding once they become effective.

At the same time, financial markets evidence tightening liquidity situation expressed in terms of volatility, increasing liquidity premia and restraint liquidity supply, both in volume and tenor.

The combination of increasing regulatory (minimum-) requirements and increasing liquidity costs necessitate an efficient management and steering of liquidity in order to achieve an optimal level of compliance and to avoid extra-ordinary liquidity buffers and associated costs.

Liquidity requirements such as LCR and NSFR, as currently stipulated by known drafts of Basel III and CRD IV, respectively, will have much more significance for liquidity management and steering due to their pronounced stress-orientated design, which is more demanding than current national regulatory liquidity requirements in place


Contact: Arno Kratky

Phone: +49 (0)69 136 82657Fax: +49 (0)69 136 81264E-mail: [email protected]

Visitors’ address:Mainzer Landstrasse 15360327 Frankfurt/MainGermanywww.commerzbank.com

Postal address:60261 Frankfurt/MainGermanyPhone: +49 69 136-20E-mail: [email protected]



52

Disclaimer

Investor Relations

This presentation contains forward-looking statements. Forward-looking statements are statements that are not historical facts; they include statements about Commerzbank’s beliefs and expectations and the assumptions underlying them. These statements are based on plans, estimates and projections as they are currently available to the management of Commerzbank. Forward-looking statements therefore speak only as of the date they are made, and Commerzbank undertakes no obligation to update publicly any of them in light of new information or future events. By their very nature, forward-looking statements involve risks and uncertainties. A number of important factors could therefore cause actual results to differ materially from those contained in any forward-looking statement. Such factors include, among others, the conditions in the financial markets in Germany, in Europe, in the United States and elsewhere from which Commerzbank derives a substantial portion of its revenues and in which it hold a substantial portion of its assets, the development of asset prices and market volatility, potential defaults of borrowers or trading counterparties, the implementation of its strategic initiatives and the reliability of its risk management policies.

In addition, this presentation contains financial and other information which has been derived from publicly available information disclosed by persons other than Commerzbank (“external data”). In particular, external data has been derived from industry and customer-related data and other calculations taken or derived from industry reports published by third parties, market research reports and commercial publications. Commercial publications generally state that the information they contain has originated from sources assumed to be reliable, but that the accuracy and completeness of such information is not guaranteed and that the calculations contained therein are based on a series of assumptions. The external data has not been independently verified by Commerzbank. Therefore, Commerzbank cannot assume any responsibility for the accuracy of the external data taken or derived from public sources.

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