Funds-transfer-pricing in banks: What are the main drivers?

Highlights

• Compared with other areas of asset and liability management (ALM), regulation is on the lighter side for funds transfer pricing (FTP), leaving banks with a broad range of operations.
• FTP drivers used by banks generally fall into three areas: attempts to price risk into products, attempts to price regulatory cost into products, and subsidization of product lines according to management perceptions of business requirements.
• We’re investigating the reasons a bank might choose one approach over another, and show why banks might want to align risk-based pricing as a primary driver in their FTP frameworks while presenting other factors as transparent modifications.
   

Introduction

​​Funds transfer pricing in banks is not a new concept. It came back into focus following the Global Financial Crisis, when it became apparent that the increased funding costs for banks had not been priced into products. Many unprofitable businesses have been recorded as a result. Figures A1 and A2 illustrate how a spike in long-term wholesale funding costs during the crisis was not priced into new mortgage lending in the UK.

This mispricing inspired several regulatory bodies to issue communications on the subject of FTP. However, compared to the proscriptive nature of other post-crisis regulations, instruction on FTP has stayed broad and high-level. The United Kingdom Prudential Regulation Authority (PRA), for example, which regulates UK Banks, has only one line in their regulatory handbook referring to FT¹, although it is included as a key aspect of their supervisory reviews. The United States Federal Reserve (The Fed) has issued a paper on FTP, as has the Committee of European Banking Supervisors, with both positioned as guidance rather than requirements². On a global level, the only relevant paper is a Bank for International Settlements (BIS) Occasional Paper written in 2011.³

Banks, therefore, have been left with a wide remit when designing their FTP frameworks. Below, we explore three categories of methodology and the reasons Banks might choose one, or continue to ignore FTP frameworks altogether.
 

Using FTP to price risk into products

Which banks choose this approach?

During the global financial crisis, many banks, particularly those heavily funded by wholesale markets, suffered from a jump in funding costs. Figure 2 illustrates this increase. Pre-2007, the differential between what many banks paid for long-term funding and the ‘risk-free’ rate was negligible. Post-crisis, it became impossible to ignore, and that is the way it has stayed. Correctly pricing a term liquidity premium (TLP) into products alongside pricing interest rate risk, has become a focus for many banks.

Figure 2: The Increased Importance of Term Liquidity Premium

Interest rate risk and term liquidity are not the only risk types where an FTP framework can be used to price risk into products. Figure 3 shows the results of a Moody’s survey of 160 industry professionals, indicating the variety of risk factors being considered for inclusion in FTP.

Figure 3: Components Used in the FTP Calculation Process

As outlined in Figure 3 above, term liquidity premium is seen as one of the most important risks to price. However, there are banks where the TLP concept is not seen as significant, and these banks tend to fall into two categories.

• Banks operating in jurisdictions where market interest rates, retail deposits, or both, and lending rates are subject to heavy government intervention. They often see no benefit in an FTP mechanism to transfer costs, because rates are fixed and change infrequently. 
• Banks where funding originates primarily from non-wholesale sources. These banks might still see value in an FTP system to transfer other risks into product pricing, however, such as basis, optionality, or foreign exchange (FX) risk.
   

The concept

Even when banks choose the same risk components, the methods they use can vary significantly.

When dealing with interest rate risk, methodologies often involve isolating the 'risk-free rate.' In liquid markets, this is often identified as the swap rate, although it becomes more challenging in illiquid or closed currency jurisdictions. The selection of the point on the curve for charging assets and paying liabilities depends on whether or how behavioral analysis is conducted at a portfolio or product level. Occasionally, the same reference FTP rate is applied to all transactions, and a 'basis risk' split assesses the difference between the reference and risk-free rate.

As previously mentioned, interest rate risk and liquidity risk in the form of Term Liquidity Premium are commonly considered important parts of a fund transfer pricing framework. The assessment of Term Liquidity Premium involves isolating the spread between the firm's actual 'cost of funds' and the risk-free rate. Different methodologies exist, ranging from using wholesale issuance curves to referencing a basket of competitor credit default swaps. Adjustments to the curve may be made by considering the costs of other funding sources for the bank, such as retail funding or capital. Additionally, some banks adopt the practice of applying different costs of funds to different business units.

The incorporation of different risk components varies widely among banks, influenced by product characteristics or the necessity to centralize specific risks away from business unit management. For option risk, the cost of a cap, floor, or prepayment option can be priced and converted into a spread. If the bank has products with coupons that are linked to inflation, inflation swaps are utilized to price inflation risk, contingent on the availability of a liquid market for such swaps. Additionally, if a transaction is issued in one currency but funded in another, an FX swap can be added to the reference curve. While some banks aim to isolate a credit risk component, it's often considered the residual part of the client rate and managed by business units, falling outside the FTP charging process.

The reason for using fund transfer pricing in banks to incorporate a risk price into product prices is to remain competitive and ensure that products are not incorrectly under-priced or over-priced. Even though it is accepted that risk-based pricing is the ‘best practice’ basis for an FTP banking framework, methodologies can vary significantly across institutions.
 

Using FTP to price regulatory cost into products

Which banks choose this approach?

Often termed an ‘unintended consequence’ of regulation, many banks now look to augment, or even override drivers related to internal risk assessment, by directly linking product pricing to regulatory cost. Due to regulation acting as a ‘one size fits all’ approach, the result is higher costs for products penalized by regulation and lower costs for products overlooked by regulation.

The most prevalent example of this phenomenon is including the ‘costs’ of meeting the Liquidity Coverage Ratio (LCR) into product pricing. The LCR forces banks to hold a portfolio of high-quality liquid assets (HQLA) which yield a comparatively poor return. This requirement, along with its status as a binding constraint for many banks, has led to the LCR being a commonly referenced regulatory cost in FTP frameworks.

Figure 4: Binding Constraints

Figure 4 illustrates the range of regulatory constraints affecting banks and highlights the constraints that are the most binding. Liquidity coverage ratio (LCR) was revealed as the most binding factor in the banks surveyed, surpassing any internal liquidity ratio or internal/external capital ratios. It is no wonder then, that banks have started using all the tools at their disposal, including fund transfer pricing, to navigate these constraints, turning regulatory limitations into tangible business costs.

The concept

To transfer LCR costs, methods often involve assessing the 'cost of carry' for the liquidity buffer. This cost is then distributed using LCR impact as an allocation key, by weighting how costs are distributed between balance sheet items. Some firms allocate costs only to liabilities where an LCR ‘outflow’ is generated, while others assign costs to both liabilities and assets. The latter incentivizes assets, creating LCR 'inflow,' theoretically reducing the size of the necessary liquid asset portfolio holdings.

Certain banks have been looking at incorporating net stable funding ratio (NSFR) costs into their FTP banking frameworks. The NSFR requires long-term, stable funding against a portion of the asset book, potentially increasing the overall funding cost. This approach is less common than incentivizing LCR, mainly due to it being a binding constraint for fewer banks. Additionally, some banks manage NSFR compliance through alternative means, such as governance related to product match funding.

It should be noted that, once again, incorporating such regulatory costs into product pricing is not relevant to all banks. In Asia, for example, an abundance of retail funding ensures that ratios such as the LCR and NSFR are way over regulatory minimums, making regulatory cost transfer irrelevant. For banks in the Middle East, Sharia-compliant HQLA can be costly⁴, so transferring this cost is particularly important.
 

Using FTP to subsidize particular product sets over others

Which banks choose this approach?

Proponents of ‘pure’ FTP would argue that adding overlays of incentives and subsidies undermines the goal of FTP, which is transparent risk-based pricing. This view is held by several regulators, who subject such practices to specific scrutiny. However, every bank operates in this manner to some extent, and it is therefore worth exploring best practice methods of operation.

The concept

FTP frameworks are controversial, as they alter business unit revenue. Some argue that employing risk-based funds transfer pricing in banks is overly simplistic. Business managers may contend that specific growth portfolios require short-term subsidies for market establishment, or that certain product sets enable cross-selling. The debate frequently revolves around the necessity for competitiveness with peers.

Whatever the reason behind an alteration to a risk-based FTP price, adhering to best practices demands transparency. Many banks continue to calculate what the risk-based FTP price would be and then show any incentive separately. This approach makes it obvious to management that the product is being subsidized, and that if it were not subsidized, the profit margin on the product would be negative. Banks can enhance accountability by mandating regular reapproval of subsidies or alterations through a relevant governance committee. This committee can continuously assess the validity of justifications over time. 

Providing transparency where a mixture of both risk-based and incentive-based drivers are used in fund transfer pricing can be a challenge. Complexity increases when you overlay many different products on a diverse balance sheet. In these cases, FTP banking frameworks cannot be operated without sophisticated software that can split the risks and incentives into separate components.
 

Conclusion

Funds transfer pricing is a tool at banks’ disposal to guide the shape of the balance sheet. Regulation in this subject area is comparatively light, leading to a fair amount of divergence in banks’ methodologies and approaches.

In banks utilizing FTP frameworks, the practice of pure risk-based pricing is frequently modified. This can involve incorporating regulatory costs and business incentives or subsidies. On the other hand, some banks view fund transfer pricing frameworks as less pertinent, particularly in jurisdictions with tightly controlled market rates and less stringent regulatory ratios affecting funding.

In our view, banks that maintain FTP frameworks must recognize the need for strong governance, to ensure that they achieve the goals originally intended when frameworks were put into place. A comprehensive tool that manages granular data and segregates risk components is also essential for transparency and achieving a controlled implementation of funds transfer pricing policies.

Footnotes:

¹ PRA Handbook; CRR firms ILAA 6.1. It should be noted that there is more extensive guidance for Building Societies.

^2. Fed; Interagency Guidance on FTP. Mar 2016. CEBS; Guidelines on Liquidity Cost Benefit Allocation. 2010. Application from 2012.

^3. BIS; Occasional Paper No 10. Liquidity Transfer Pricing; a guide to better practice. Dec 2011.

      ^i. Based on secondary market yields for major UK lenders’ 5 yr euro senior unsecured bonds or proxies.

      ^ii. Quoted rates on 2 yr 75% LTV mortgages for the major UK lenders

^4. Islamic Financial Services Board; Guidance note on quantitative measures for liquidity risk management. Apr 2015.