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Home > Balance Sheets Best Practice > Pricing Framework for Banks’ Internal Funds: A Best-Practice Methodology

Balance Sheets Best Practice

Pricing Framework for Banks’ Internal Funds: A Best-Practice Methodology

by Moorad Choudhry

This Chapter Covers

  • Post-crash, the regulatory emphasis is on banks to put in place robust liquidity risk management frameworks, including a robust and fit-for-purpose internal funds pricing regime.

  • The objective of funds transfer pricing (FTP) is to ensure that banks accurately build into customer pricing the true value of term liquidity.

  • The template FTP regime that is recognized as business best practice is one in which all liquidity and interest rate risk is centralized in the bank’s treasury function, thereby insulating the business line from market and funding risk.

  • Both sides of the balance sheet must be included in the FTP mechanism. This ensures that business lines that raise liabilities of equivalent term liquidity value are recognized for this activity.

  • The FTP mechanism is managed by treasury, which adds the appropriate term liquidity premium rate on to the bank’s short-term cost of funds when calculating the correct internal funding rate for the business lines.

Introduction

In the immediate aftermath of the 2008 financial market crash, bank regulators moved to implement a stricter regime of supervision, which emphasized inter alia a more controlled approach to banks’ liquidity risk management. Features of the new requirements included:

  • increased self-sufficiency in funding;

  • a more diversified funding base;

  • longer average tenor of liabilities;

  • a “liquidity buffer” of high-quality, low-risk government securities.

These recommendations were welcomed and came to be seen as part of a wholesale paradigm shift in the basic banking business model, which hitherto had relied excessively on short-term and wholesale, undiversified funding.

Surprisingly, the initial response of the regulators did not address another critical issue in banking operations: how funds are managed internally. In truth, how banks structure their internal funds pricing can influence significantly 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 where deemed necessary. In due course, regulators such as the UK Financial Services Authority (now the Prudential Regulatory Authority, or PRA) did focus on banks’ internal funds pricing regimes, known somewhat confusingly as funds transfer pricing (FTP), and today the way a bank arranges this side of its liquidity risk management framework is closely scrutinized by the PRA.

We define liquidity risk as the risk of being unable to raise funds to meet payment obligations as they fall due, and to fund the purchase of assets when necessary. Funding risk is the risk of being unable to borrow funds in the market. The PRA-prescribed mechanism to mitigate liquidity and funding risk is notable for its focus on the type, tenor, source, and availability of funding, exercised both in normal and in stressed market conditions.

This emphasis on liquidity is correct, and is an example of a return to the roots of banking, when liquidity management was paramount. While capital ratios are a necessary part of bank risk management, they are not sufficient. The failure of banks such as Bear Stearns in the United States and Northern Rock and Bradford & Bingley in the United Kingdom were as much a failure of liquidity management as they were due to capital erosion. Hence, it is not surprising that there is now a strong focus on the extraneous considerations to funding.

As a result, the use of that funding within banks—including the price at which cash is internally lent to or borrowed from business lines—is an important part of a bank’s risk management and asset–liability management (ALM) infrastructure. This is because it is a driver of bank business models, which were shown to be flawed and based on inaccurate assumptions during 2007–2008.

In this article we review the rationale behind the internal term liquidity pricing premium and present a recommended best-practice policy template for FTP.

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Further reading

Books

  • Choudhry, Moorad. Bank Asset and Liability Management: Strategy, Trading, Analysis. Singapore: Wiley, 2007; chapter 29.
  • Choudhry, Moorad. The Principles of Banking. Singapore: Wiley, 2012; chapters 11–15.

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