Chapter 15 Funds-Transfer Pricing and the Management of ALM Risks

Introduction
business units productsriskprofit
1. 2.

3.

The way we determine where the risk is located inside the bank is by using the Transfer Pricing Framework The major units considered include: the lending units, the deposit-taking units, the trading unit, and the ALM desk
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transfer price
services (ALM) 2. funding
1.

*services

funds-transfer pricing, or called cost of funds (the interest payments charged when one unit lends funds to another), which is the framework to move interest rate and liquidity risks between units by affecting the accounting profitability of each unit funds-transfer pricingcost of debt funds-transfer pricing for economic capitalWACC
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Traditional Transfer Pricing and Its Problems

Traditional transfer pricing
Retail group

ALM Another bank

1. overnight inter-bank rates 2. retail deposit rate plus small spread to covering operating cost Trading Group

Problems
retail groupdeposits r or loans r ( retail group )retail group depositsloans 2. retail groupexcess fundr ALM trading or commercial loan unit 3. business units 4. r unitincentive 5
1.

Introduction to Matched-Funds-Transfer Pricing

Traditional operation for banks (p.212 Figure 15-1), the interest rate spread covers:
Administrative costs Credit loss on the loan The interest rate risk from the mismatch of the maturity

Problems:
loansfixed deposit structural IR risk between loans and fixed deposit

Remove the structural IR risk from all business units (interbank market) (p.213 Figure 152, 15-3)
structural IR risk, capital against ALM risks interbanksize maturityassetliability

ALM deskinternal media internal marketaggregate individual transactions net amountexternal market Every business unit interacts with the ALM desk as if it were an external counterparty, that is the fundamental concept of matched-funds-transfer pricing (ALM interbank interest rate) P.214 figure 15-4

ALMALM business unitsfictitious asset and liability

ALMassetliability maturity and size matchstructural IR risk ALMnet amount EC

General Rules For Matched-Funds-Transfer Pricing

1. 2. 3.

ALM maturity market rates (p.216 Figure 15-5) ALM Business unitsALM fictitious asset or liability
ALMbusiness unitALM ALMbusiness unitALM

4.

For trading unitaccess capital market ALMALM effective maturity

Trading unitVaR calculator
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Balance Sheet for Transfer Pricing (p.217 Figure

15-6)
Maturity matching and option to prepay for commercial loans Car loans according to prime rate are hedged with a series of loans of different maturities For retail unit, the whole deposits are unlikely to be withdrawn for at least, so the retail unit lends the deposit funds as a mixture of loans from overnight to 2 years The net value of each business unit is zero All available capital to support the business units is concentrated on the ALM desk
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Transfer Pricing For Indeterminate-Maturity Products

(checking accounts or primebased loans)best hedge strategy instruments (bond + option)
prime-based loansemi-floatprepay ( ) loanoptionlending unit optionALMALMcharge option premium best hedge strategy simulationmatch ()
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Allocation of Capital
After applying fund transfer pricing (p.219 Figure 15-7) lending and deposits unit structural IR riskmarket riskcredit risk operating riskEC against risk transfer pricing fund (debt)credit risk operating riskEC (equity)
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mixture of fundingALM (WACC)

1. ALMequity credit or operating problems EC 2. ALMECD ( 1)
cost = A rd + E (re rd ) (1) = D rd + E rd E rd + E re = D rd + E re (2)

ALMbusiness unitdebt equity business unitequity-raise money equityALMequity P.221, Figure 15-8 14

ALM equity cover operating riskcash liquidity risk lending unitequity against credit risk deposit unitequity depositsraise equity for operating riskcash liquidity risk equityALM ALM operating riskcosts deposit-taking businessEC ALMbalance Banks balance sheet
1. trading group 2. EC P. 221 Figure 15-8 and P. 222 Figure 15-9

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The Roles of Organization Units Involved In ALM

ALM
1.

Senior Risk Committee and the Asset Liability Committee (ALCO)

SRC monitors all risks of the bank, especially is interested in ALM book, fix income position in trading desk, and correlation of interest rate risk with other risks ALCO monthly reviews the structural IR and liquidity positions ALCO reviews transfer-pricing policy and decisions on administered rates, ex. prime rate or retail fixed-deposit rates risk profile (issue bond ) gap between assets and liabilities, ALCOtakerisk 16

2.

Asset Liability Manager

AL manager is a trader who has the daily responsibility of maintaining the interest-rate and liquidity profile targeted by ALCO It is done based on risk reports from the ALCO support group and is carried out by ordering trades such as swaps and interbank loans for the ALM books, which is an accounting entity holding all the fictitious assets and liabilities ALMtrading desk ALMbond desk AL mangertake risk EC internal marketexternal market ALMnatural hedge with no cost
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3.

ALCO support group

ALCOAL managerweekly risk report indeterminate-maturity productseffective duration fund-transfer pricing

4.

The Money-Market Funding Desk

(ensure the daily funding requirements are balanced) business unitmoney-market funding deskALM ALMmoney-market desk
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5.

Financial Accounting Group

report the profitability of each business unit ( fundstransfer pricing)

6.

Business Units
transfer-ratecontrolunit ECcapital costbusiness unit

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