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Bank Internal Transfer Pricing: One More Issue for Regulatory Authorities

by Dr Moorad Choudhry

The UK Financial Services Authority (FSA) issued a number of consultative papers in 2008 and 2009 that concentrated heavily on bank funding liquidity. The proposals are being debated at all levels but it is apparent that UK banks will have to adhere to a much stronger regime with regard to liquidity risk management. Comprehensive as the FSA review as been, it does not address to any large extent the issue of internal bank funding. Internal transfer pricing is a key issue in the business decision, and many banks have operated an artificial internal funding mechanism for their various business lines. We believe that in omitting to address the bank internal funding process, the FSA has missed targeting a key risk issue. In this article we consider how internal transfer pricing can become a cause of poor business decision making when it is applied at levels that take no account of the risk-reward profile of the business being entered into. We also provide recommendations how the internal funding mechanism can be applied in a more robust and disciplined manner. The Internal Funding Price The recent review by Lord Adair Turner, Chairman of the FSA, on the future of bank regulation, emphasised a more robust approach to bank liquidity risk management. In due course UK-regulated banks will have to demonstrate, among other things, the following features of their liquidity management policy: an increased self-sufficiency in funding; a more diversified funding base; a longer average tenor of liabilities; and a “liquidity buffer” of high quality government securities. These recommendations are to be welcomed and should, over time, be seen as part of a wholesale paradigm shift in the basic banking business model, which had hitherto relied excessively on short-term and wholesale, undiversified funding. However, the Turner report and various FSA Consultation Papers on Liquidity and Funding1 do not address a further critical issue in banking operations: how funds are managed internally. In reality, the way that banks structure their internal transfer pricing can influence significantly their risk-reward profile and the activities of individual business lines. Therefore, it is important that a bank’s internal funding framework is placed under scrutiny, with guidelines enforced by the regulator when deemed necessary. From the practitioner viewpoint, banks can also gain a competitive advantage if their internal funding mechanism is operated effectively. Pro-cyclical funding It is common to seek to strengthen external regulation during a crisis, although paradoxically this is precisely the time when it is least needed. By then, bank senior management is keen to

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

when lending and allocation decisions are looser. tenor.retrench ultra-conservative lending practices. they are not sufficient. risks related to wholesale and retail liabilities. into the remit of these new regimes. All of this comes at a time of severe economic contraction and negative consumer and capital market confidence. Hence it is perhaps not surprising that there is now a strong focus on the extraneous considerations to funding. M. However.. the use of that funding within organisations. just as we are now witnessing a steady flow of supervisory proposals addressing the twin tenets of financial health and stability in the banking world – solvency and liquidity – we are also seeing banks fight rearguard actions to address shortfalls in their capital adequacy and liquidity assessment capabilities. and to fund increases in assets. It is this risk aversion in a falling market. which is analogous to the Capital Adequacy assessment of Pillar 2 of the Basel 2 Accord. source and availability of funding. A rising cost-income ratio is one of the first signs that the economic cycle for an institution has turned. While bank capital levels are a necessary part of bank risk management.Individual Liquidity Adequacy Assessment). inter alia) is notable for its focus on the type. when in fact the cost and opportunity to implement such efficiency gains are at their most benign. This emphasis on liquidity is correct. The move towards prescriptive (rather than principles-based) regulation that characterises capital adequacy compliance under Basel 2 would appear also to be crystallised in these papers. By the same token. including the price at which cash is internally lent or transferred to business lines.2 is the current focus of three separate consultation papers issued by the FSA. 2007 . and needs little encouragement or intervention to do so. by which time it is too late to instigate effective cost reduction strategies (large scale redundancy notwithstanding). as has been well documented. which is the risk of being unable to borrow funds in the market. Liquidity and Funding It is in the areas of liquidity and funding risk management where an external/internal dichotomy can be seen to be in play. John Wiley & Sons. as well as the policies that govern these processes. as is the emphasis not just on more detailed reporting and disclosure requirements but on the mechanisms in place to compute that data. defined as the risk of being unable to raise funds to meet payment obligations as they fall due. In adding the methods to produce. the regulator is setting an Individual Liquidity Adequacy Standard (ILAS) against which organisations are assessed (through an ILAA . collate. The need for tighter supervision is at its greatest at the top of a bull market. the internal funding framework. So. aggregate and transform cash flow data. Bank Asset and Liability Management. and funding risk. and an example of a return to the roots of banking when liquidity management was paramount. which exacerbates the impact of a “credit crunch”. The management of liquidity risk. has not been as closely scrutinised. The prescribed mechanism to manage and mitigate liquidity and funding risk (including in the case of the latter. exercised in normal and stressed market conditions. This issue needs to be addressed by regulators because it is a 2 See Choudhry. The examples of Bradford and Bingley and Northern Rock were more a failure of liquidity management than capital erosion. organisations are less likely to address internal processing inefficiencies when they are cash-rich and with revenues growing. inadequate funding source diversification and asset marketability.

any mismatch between the asset tenor and funding tenor. It is also the key hurdle rate behind the product approval process and in an individual business line’s performance measurement. This will ensure that each business aligns the commercial propensity to maximise profit with the correct maturity profile of associated funding. banks should aim to develop a comprehensive framework for internal funding. banks do not always set different target ROCs for each business line. Essentially. driving sales. However. Just as capital allocation decisions affecting front office business units need to account for the cost of that capital (in terms of return on regulatory and economic capital). In an ideal world. it is a key element driving a bank’s business model. A measure of discipline in business decision-making can be enforced via the imposition of minimum return-on-capital (ROC) targets. it is crucial that the price at which cash is internally transferred within a bank reflects the true economic cost of that cash (at each maturity band). and product pricing. and from external correspondent/agent banks. so funding decisions exercised by corporate treasurers carry significant implications for sales and trading teams at the trade level. the price at which an individual business line raises funding from its Treasury desk is a major parameter in business decision making. a uniform cost of funds. which means that the required discipline breaks down. FSA CP 08/22. However. should be highlighted and acted upon as a matter of priority with the objective to reduce recourse to short term. to ensure that the bank carries a flat cash position at the end of the trading cycle. each business line should be set ROC levels that commensurate with their (risk-adjusted) risk-reward profiles. Strengthening Liquidity Standards. It is important that the internal funding framework be transparent to all trading groups. This is essential to the funding mechanism. Given this fact. From a liquidity point of view. Independent of the internal cost of funds. will mean that the different liquidity stresses created by different types of assets are not addressed adequately. Middle Office or Operations needs to ensure that funding projection is calculated and reported daily. for example timely data transfer between front office and settlement systems. adjusted for the relative risk of the asset. that must be underpinned by cash flow information sourced from the general ledger. However. and accurately reflects the risk-adjusted value-at-risk of the business line in question. Second. which were shown during 2007-2008 to be flawed and based on inaccurate assumptions.driver of bank business models. An Effective Internal Funding Framework While the FSA consultation paper does touch on banks' internal liquidity pricing. For example. passive funding as much as possible. even allowing for different ROCs.3 the coverage is peripheral. December 2008 . For the measure to work. consider the following asset types: 3 See page 23. given the impact of any disparity between perceived and actual views of the world on lost opportunity and direct interest rate costs. The need for greater cohesion to enforce greater collaboration between these groups becomes compelling. asset allocation. relying solely on this discipline measure may not be sufficient. a business line would ordinarily seek to ensure that any transaction it entered into achieved its targeted ROC. and is supported by effective processes and technology. Effective reporting is part of the internal funding mechanism. after taking into account the “repo-ability” of each asset class in question.

a 3-year fixed-rate loan. Working Paper. rather than the true economic value-added of the business. the desk could report super profits and very high return-on-capital. Its derivatives trading arm. which encouraged more and more risky investment decisions. an 8-year floating rate synthetic CDO note. KBC Financial Products. despite the fact that it was investing in assets of lower liquidity and quality than inter-bank risk. A. This lack of funding discipline undoubtedly played an important role in the decision making process. P. The Sub-Prime Crisis: Causal Distortions and Regulatory Reform. which originated and invested in collateralised debt obligations (CDO). As a stand-alone business. because it allowed the desk to report inflated profits based on low funding costs. and Atkinson. UBS structured credit business was able to fund itself at prices better than in the market (which is implicitly inter-bank quality and risk). Adrian Blundell-Wignall and Paul Atkinson4 (2008) discuss the heavy losses suffered by UBS AG in its structured credit business. and at a rate that reflects the true risk position of the individual business line. There was no adjustment for tenor mismatch (to better align term funding to liquidity).a 3-month interbank loan. the impact on the liability funding desk is different for each asset. A more realistic funding model was viewed as a “constraint on the growth strategy”. a CDO investor would not expect to raise funds at sub-LIBOR. a 10-year floating-rate corporate loan fixing monthly. This profit will reflect the funding gain. We see then the importance of applying a structurally sound transfer pricing policy. there is a risk that transactions are entered into that produce an inflated profit. the cost at which funds are lent from central Treasury to the business lines needs to be set carefully. Even allowing for different credit risk exposures and capital risk weights. If it is artificial. “…internal bid prices were always higher than the relevant London inter-bank bid rate (LIBID) and internal offer prices were always lower than relevant London inter-bank offered rate (LIBOR).” (p 97) In other words. We have deliberately selected these types to demonstrate the different pressures that each type of asset places on the Treasury funding desk (the lowest funding rollover risk first). OECD. July 2008 . was funded by the parent at a fixed spread funding rate 4 Blundell-Wignall. On 30 June 2009 The New York Times reported on the KBC Bank NV case.. By receiving this artificial low pricing. a 3-year floating-rate corporate loan fixing weekly. a 3-year floating rate corporate loan fixing quarterly. Cost of Funds We have noted that as a key driver of the economic decision-making process. They quote a UBS shareholder report that stated. but rather at significantly over LIBOR. and a 15-year floating-rate project finance loan fixing quarterly. In their paper. There is considerable empirical evidence on the damage that can be caused by artificially low transfer pricing.

Conclusions It is important that the regulatory authorities review the internal funding structure in place at the banks they supervise. it is worth them looking beyond the literal scope of the new supervisory fiat to consider the internal determinants of an efficient. and the project finance desk. The firm’s asset portfolio however. while funding itself at the same low LIBOR-plus transfer price. For the most efficient capital allocation. Otherwise they run the risk of excessive risk taking driven by artificial funding gain. banks should adjust the basic internal transfer price for the risk exposure of the business. The corporate lending desk will create different risk exposures for the bank compared to the CDO desk. A fixed add-on spread for term loans or assets over a certain maturity. An artificially low funding rate can create as much potentially unmanageable risk exposure as an inadequate liquidity management regime.of LIBOR plus several basis points. say two years. It would also allow for the different risk-reward profiles of different asset classes. Much of the profit reported by the CDO business was an artificial funding gain (which took no account of the risk weight of the assets). difficult to unwind). Dr Moorad Choudhry is Head of Treasury at Europe Arab Bank. A regulatory requirement to impose a realistic internal funding arrangement will mitigate this risk. invested in CDO bonds that were exposed to securities with a rating as low as BB. to compensate for the liquidity mismatch. and author of Bank Asset and Liability Management. cost effective funding regime. among others. Many banks operate on a similar model. such an approach does not take into account the differing risk-reward profiles of the businesses. The firm’s hedge fund derivatives desk operated on a similar basis. where the coupon re-fix is frequent (such as weekly or monthly). However. with a fixed internal funding rate of (say) LIBOR plus 15 bps for all business lines. extending loans to hedge funds or fund of funds via long-term products that were illiquid (and hence. published by John Wiley & Sons (Asia) Pte Limited . based on the median credit risk of the individual business line. Internal funding discipline is as pertinent to bank risk management as capital buffers and effective liquidity management discipline. The spread can be in a sliding scale for longer-term assets. This would be analogous to the way the Sharpe ratio is used to adjust returns based on relative volatility. We recommend the following approach: A spread over the internal transfer price. and for any tenor. In this way they can move towards the heart of this proposition. As banks adjust to the cost of compliance with the new liquidity requirements soon to be imposed by the FSA. . which is to embed true funding cost into business-line decision-making. rather than true economic value-added.