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Transfer pricing: Pitfalls in using multiple benchmark yield curves Shih, Andre Today most banks clearly understand the need to segregate interest rate risk from the operating results of line units. And most are instituting transfer pricing systems to accomplish this objective. Instituting a transfer pricing program, however, will not guarantee that a bank will actually succeed in isolating interest rate risk. The specific transfer pricing methodologies that the bank chooses can have far-reaching implications for the effectiveness of its program. One of the key methodological choices that banks currently face is the decision to employ single or multiple benchmark yield curves. (At many institutions these yield curves are referred to as funding curves.) This paper will demonstrate that, while the multiple curves option may appear desirable at first glance, the actual use of a multiple-curve methodology will have serious and detrimental consequences for the transfer pricing program. The most serious of these include: * Misallocation of resources; * Inconsistent margin comparisons among products; * Inaccurate measurement of the total interest rate risk of the institution; * Improper inclusion of credit risk in interest rate risk. If left uncorrected, these deficiencies will in turn lead to such serious practical consequences as inaccurate hedging, incorrect measurement of treasury/funding center performance, and product mispricing. The negative impact of multiple benchmark yield curves will ultimately pervade many different aspects of profitability and risk management. The process is similar to compressing a balloon; when we squeeze down on one end, the other end distorts or ruptures. We need to keep in mind the stated objective for the transfer pricing process, namely, to provide an accurate understanding of the net interest margin contribution to profitability for any dimension we want to measure, such as product, business unit, or customer. Accurate transfer pricing removes interest rate risk from the line operating units, which have no control over the interest rate environment, and centralizes the risk in a funding center that is usually a unit within the Treasury. It thereby enables the bank to measure the actual operating performance of its various business elements in more accurate and productive ways. Because it is a critical factor in the measurement of net interest margin contribution, the transfer pricing process has far-reaching impact on all decisions driven by profitability-based performance measures, from product pricing through customer relationship management. It will ultimately influence all dimensions of resource allocation, including decisions on customers and distribution channels as well as products.

such as embedded options. it can borrow only at the market rate currently available to institutions with its particular credit rating (the marginal funding cost). Once an institution has gotten this far in the transfer pricing process. it faces a subtle danger. Mortgage products may also present unique features. the two instruments yield a net interest margin of 3. An institution cannot borrow on an average funding cost basis. a 0. special cost and price information is readily available. Some others argue that the FHMLC investment rate should be used. Its financial analysts have convinced its senior executives and line business managers that accurate transfer pricing is essential to the proper and precise measurement of profit contributions. Line units will have no control over the latter unless they institute hedging programs of their own. Line units can and do affect the repricing characteristics of products with "administered rates" (such as credit cards and interest-bearing checking accounts) by changing pricing strategies in response to shifts in market rates. which are openly and widely traded in financial markets. deposits. The choice of the proper cost of funds benchmark is a critical one since it determines how profitability contributions to net interest margin are measured. specialized funding curve. No other mechanism would ever gain acceptance with business managers whose profit results and performance ratings are being affected.5%). Assume that an institution has only two items on its balance sheet: a 2-year duration deposit on which it pays a 6. and interest rate risk. it will lower the profitability contribution of loans and increase the profitability contribution of deposits. and interest rate risk proper.5% net interest margin into a 2% net interest margin on loan (10%-8%). For an asset rich institution. In these cases. marginal refers to the rate the bank would pay to borrow the next increment of funding in the market. since the institution would presumably exhaust other and cheaper funding sources first. Hence. But we should not confuse control over prices with control over the interest rate environment itself. while a marginal wholesale funding curve should be used for all other items. Institutions that need to meet marginal funding requirements with wholesale borrowing usually select a marginal borrowing (or funding) curve. Some analysts have argued that the FHMLC borrowing cost should be used to transfer price all mortgages. Mortgages are especially appealing candidates for separate benchmarks since these assets have counterparts.5% (10%-6. Together. A simple example will illustrate how this process allows an institution to measure profit correctly. for example. The market of reference will usually be the wholesale market. such as mortgage portfolios and mortgage-backed securities. Institutions that have excess deposits tend to select a marginal investment curve for their benchmark. Figure 1 shows how transfer pricing allows the institution to decompose its 3. It is not unusual. but must be market determined. Note that the operative word here is marginal. deposit contribution.5%). The example makes it clear that the bank needs a benchmark in order to identify the different contributions of loans.5% net interest margin on deposit (7%-6. If the bank sets the benchmark cost of funds higher. transfer pricing assumptions about margins should be adjusted to take pricing responses and customer reactions into account. THE HIDDEN IMPACT OF MULTIPLE YIELD CURVES . that seem to demand the use of a separate. to see institutions select a mortgage curve to transfer price mortgages while using the institution's wholesale funding curve for all remaining assets and liabilities. transfer pricing allows an institution to decompose the contribution to net interest margin into loan contribution. Assume further that the institution is asset rich and can borrow in the wholesale market at 7% for 2 years and 8% for 7 years. Note also that average cost would not be a meaningful concept in this context. Properly implemented. It is clear that a benchmark cannot be arbitrary.Exactly what constitutes interest rate risk can be a source of confusion at some institutions.5% interest rate and a 7-year duration mortgage on which it receives a 10% interest rate. and an interest rate risk mismatch of 1% (8%-7%). which raises a number of other issues that will warrant a separate article. Can the institution not gain even more precision by selecting individual benchmark curves for each type of product or business line? Some institutions have decided to try this approach.

There is an even more subtle source of error that can occur when institutions use mortgage agency borrowing costs as a benchmark.5% based on its wholesale funding curve. Specifically.5% (9% 7.0%). however. Assume further that the 5-year mortgage agency borrowing cost was at 8.5% (7.7. the 2% net interest margin (9% .7%) and a zero interest rate risk (7. Let us assume further that both items are bullet securities of equal duration.5% to 0. In addition. for example. say five years.5% (7.5%). the differential in credit risk will be posted to the funding center as interest rate risk. This misleading result clearly distorts the institution's real position. Fannie Mae. The following simple example demonstrates these hazards. A wholesale funding curve.5% . A third deleterious effect of the multiple curves approach is that it creates inconsistencies in net interest margin. The net interest margin contributions of securities transfer priced with one benchmark yield curve are no longer . a liability net interest margin of 0. that when the benchmark yield curve used to transfer price the asset differs from the curve used to transfer price the liability. the financial results of the interest rate risk center can no longer be interpreted as measuring the institution's success in controlling interest rate risk. let's assume an alternate case where the institution elected to use a mortgage funding curve for the loan while using its wholesale funding curve for the deposit. the total spread in the funding center's funding books can no longer be interpreted as representing the institution's total interest rate risk. But the hidden consequences of this multiplecurves strategy can be both detrimental and far reaching. As Figure 2 shows. This institution is perfectly matched and thus should not have any interest rate risk at all.5% . for example. Assume an institution has a very simple balance sheet with one asset and one liability. enjoys a higher credit rating than many commercial banks.7%) of the institution can be decomposed into an asset net interest margin of 1. by contrast. and its lower borrowing costs reflect its higher credit rating. and the institution could borrow for 5 years at 7. Unless the institution has the ability to isolate the effects of the differences between the two curves and adjust for the discrepancy. the 5-year deposit paid a rate of 7%.Arguments like these appear very convincing.6% now resides in the funding center and represents the differences between the two transfer pricing curves at the 5-year point (8. will reflect the credit risk of either the underlying mortgage instruments or the mortgage agency. once multiple curves are introduced into a transfer pricing system. the net interest margin on the asset has now decreased from 1. Most importantly. The liability net interest margin remains unchanged at 0. Going back to the example above. An institution that uses Fannie Mae borrowing costs as the benchmark yield curve for its mortgage funding is confounding Fannie Mae's credit position with its own. especially when applied to assets like mortgages. A second and equally serious consequence of a multiple curves strategy is that it may effectively mix interest rate risk with credit risk. The remaining difference of 0. Unless the two are exactly equal. Note.7. let us assume that the 5-year loan earned a rate of 9%. will reflect the institution's own credit risk. Its funding center should show a net interest margin of zero. the funding center will show a net interest margin contribution equal to the difference between the rates of the two benchmark curves at the five-year point. much less measure its success in controlling that risk.1%). The first and most obvious consequence is that the strategy undercuts the foremost objectives of transfer pricing: the proper measurement of business performance independent of interest rate risk and the corresponding centralization of interest rate risk measurement and management within a funding center. How would the 2% net interest margin be decomposed when applying these two different transfer pricing curves? As Figure 3 shows.5%). A mortgage curve.5%-7. For example. and the funding center may expend money and energy to hedge exposures that really represent credit risk.9% (9%-8. the institution will now have altered its measurement of net interest margin contribution in significant ways. it will not be able to identify its true interest rate risk.1% . Different benchmark curves are very likely to represent different underlying credit risk profiles.1 %.5%).

and subsequently into pricing and profitability decisions. In financial institutions. it is improper to pursue two different purposes simultaneously. The deleterious effects of multiple benchmark curves may seem academic at first glance. Please note that the arguments we are setting forth do not apply to the use of multiple benchmark curves to transfer price balance sheet items in different currencies. We can be certain that our error will pop up at some other point on the surface. There are more straightforward and accurate tools available for capturing this risk. Incorrect Hedging . enterprise-wide misallocation of resources. We are quite literally measuring net interest margin contributions with two different yardsticks. It is therefore critical that an institution identify all the ramifications that a technique or method will have for downstream decisions. Introducing errors at any one point is like pressing down on any point on the surface of a balloon. And they may seriously misjudge the impact of their decisions on customer relationship management and distribution channel mix. but their actual consequences are not trivial. There are at least five points at which the use of multiple transfer curves can introduce error or inaccuracy into an institution's risk management practices. It is. The confusion can grow particularly acute when we consider securities with embedded options. The objection to this practice is a simple one. Otherwise. and they do not introduce the problems associated with multiple curves. initiates a chain reaction that can affect structures as distinct as the performance incentive system. Systematically Misdirected Focus and Performance Incentives The introduction of error into interest rate risk measurement. institutions should develop a separate estimate of the option using a stochastic option valuation tool with parameters calibrated to market prices. and then consider the results comparable. the use of multiple benchmark yield curves will ultimately lead to serious. When embedded option risk is an issue. a given yardstick selected for a given purpose should be applied consistently throughout the transfer pricing process. The cumulative effect of these influences can be a systematic misdirection of business focus brought about by errors in performance evaluations and counterproductive performance incentives. Institutions will make resource allocation decisions based on incorrect information. Interest rates in Germany or Chile may shift in opposite directions for completely unrelated reasons. forfeiting proper (and attainable) returns. They may well end up selling the wrong products. decision-making is a complex process that depends on an extensive web of information relationships. mixing of credit rate risk with rate risk will persist.comparable with those transfer priced with a different benchmark yield curve. A bank cannot apply one yardstick to one subset of business and a second yardstick to another subset. For results to be meaningful. Each currency in which a bank deals represents a distinct and independent source of interest rate risk. The market prices of these securities will generally vary with interest rates shifts. therefore. When tainted results from the transfer pricing system are used for managing the operations and risk of the business. and net interest margin contributions will not be comparable. Although it is legitimate to use different benchmark curves for different purposes. The cumulative effects of these errors can significantly affect the institution's overall profit performance. entirely appropriate for a bank to apply a separate benchmark yield curve to each of the currencies in which it operates. and pricing products out of the marketplace. Some analysts have suggested that the use of multiple curves will allow an institution to capture these shifts in market price.

The institution may. in the worst case. As a result. Consider one brief example. These results are also used to determine provisions of the incentive system. will prevent an institution from properly identifying such cases.If the results of the funding center do not accurately reflect the total interest rate risk of the institution. operational. As we noted. Incorrect Capital Attribution Best practice institutions tend to develop their capital attribution estimates by decomposing capital requirements according to sources of risk: credit. a means of decomposing a net interest margin total which will remain constant regardless of the methods we use to carve it up. the use of multiple curves often mixes credit and interest rate risk. for example. Such mixing leads to improper estimates of the volatility of the funding center and. and thus has real impact on all the . consequently. and so forth. such as the use of FHMLC borrowing costs mentioned above. The historical performance of the funding center may reflect a number of factors other than interest rate risk. Profit margins on most banking products are generally very thin. this literal characterization is certainly true. Such approaches tend to be messy. In addition. interest rate. If we look only at the mechanics of the transfer pricing process. of the capital required for interest rate risk. They have elected to adjust their performance measures by such methods as changes in hurdle rates and capital allocations. Pricing based on such curves will also be flawed. Mispricing If inaccurate risk measures are used in pricing decisions. But almost every institution that uses a transfer pricing system takes the process further. the institution will not be able to measure the effectiveness of its hedging policy accurately. Under these circumstances. consumer finance companies tend to have low credit rating due to the higher credit risk characteristics of their borrowers. the costs of incorrect hedging could become very significant. For example. use its interest rate risk measures to help decide whether it should provide a given product. Some observers may argue that transfer pricing is really a zero-sum game. The results of transfer pricing calculations are net interest margin contribution figures. Bad pricing decisions will reduce stockholder value as surely as bad credit decisions. The use of a funding curve that does not reflect the institution's true credit risk. which are often used to measure and evaluate performance as well as to support the decision-making process. Improper Interest Rate Risk Performance Measurement If the measurement of interest rate risk is inaccurate. any attempt to hedge interest rate risk based on funding center measures will by definition prove incorrect. since those would tend to be uneconomical by definition. and they require intensive maintenance in the form of the multiple analytical processes needed to track impacts accurately over time. a "hedging" program could exacerbate the interest rate risk of the institution if the measurement process yields a risk position opposite to the true rate risk position of the institution. In the worst case. their borrowing costs tend to be higher than those of traditional retail banks. and small errors in interest rate risk measures could produce significant swings in perceived profitability. These finance companies would experience negative spreads if they invested in the highest rate investment grade securities. Most bankers agree that institutions should shy away from offering competitivelypriced products that have less credit risk than itself. transfer pricing directly affects employee behavior. An institution might abandon genuinely successful strategies or. then the effects of the inaccuracies may be amplified throughout the enterprise. persist in strategies that are actually unprofitable. Some institutions that have linked measurement and goal setting have understood that they must adjust for the impact of multiple curves in order to encourage proper behavior.

Pennsylvania. At time of original publication. By Andre Shih. Volume 11. and Steven Wofford* Copyright National Association for Bank Cost & Management Accounting 2000 Provided by ProQuest Information and Learning Company. California. No. it also plays a material role in determining how large the pie will be. and David Crandon was a Vice President of Management Science Associates. Los Angeles. 2. Pittsburgh.operations of the institution. *Reprinted from Journal of Bank Cost & Management Accounting. Seen in this light. All rights Reserved . Andre Shih and Steven Wofford were Directors of Treasury Services Corporation. David Crandon. transfer pricing is not just a method for slicing up the net interest margin pie.