Welcome to the presentation

Risk Management in Banking Course: B-505 Presented By : Md Tarek Hossen ID-12-40

Chapter 26 Fund Transfer Pricing SystemsChapter 26

Tools
1. 2.

for risk management

The Funds Transfer Pricing system (allocate interest income) The capital allocation system (allocate risks) Transfer prices serve as reference rates for calculating interest income of transactions, product lines, market segments and business units.

The FTP System Specifications

Transferring funds between units. Breaking down interest income by transaction or any subportfolio such as business units. Setting target profitability for business units. Transferring interest rate risk to ALM. Pricing funds to business units with economic benchmarks. Combining economic prices with commercial incentives.

The Goals of The Transfer Pricing System

Allocate funds within the banks Calculate the performance margins of a transaction. Define economic benchmarks for pricing and performance. measurement purposes. Define pricing policies. Provide incentives or penalties. Provide mispricing reports, making explicit the differences. Transfer liquidity and interest rate risk to the ALM unit.

Funds Transfer Pricing

Funds Transfer Pricing system and its applications.
Allocate funds Measure performance Fund Transfer Pricing system

Pricing Transfer risks to ALM Define economic benchmarks

Economic transfer prices

INTERNAL MANAGEMENT OF FUNDS AND NETTING

1.

2.

a. b.

ALM, Treasury and Management Control (Unit in charge of managing the liquidity & interest rate exposure of the bank) Internal Pools of Funds (virtual location where all funds ,excesses & deficits are centralized) Netting Pricing all Outstanding Balances

Netting
Transfers of net balances only
Market
Sale of resources to A Purchase of net excess of B

Central pooling of net balances

Business unit A Deficit of funds Business unit B Excess of funds

Pricing all Outstanding Balances Transfer Pricing

The central pool of all assets and liabilities
Market

Sale of all uses of funds Purchase of Central all resources pooling of net Purchase of balances Sale of all uses all resources Business unit A of funds Business unit B

MEASURING PERFORMANCE

The commercial margin Spread between customer prices and internal prices. The financial margin Volumes exchanged + the spreads between internal prices and the market prices used to borrower invest.
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MEASURING PERFORMANCE

For

the bank . Sum all revenues and costs from lending and borrowing. For the business units. Revenues result from customer prices (-) the cost of any internal purchase of resources by the central unit. For the ALM unit. Revenues result from charging the lending units the cost of their funds.
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ALM AND BUSINESS UNIT PROFITABILITY GOALS

ALM

Profitability and Risks Target Commercial Margins

Setting

Mbank = Mcommercial +MALM

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Setting Target Commercial Margins

Policies and profitability of ALM

Risks Return

ALM P&L Maintain risk within limits

Minimize funding cost Maximize investment return

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THE FINANCIAL AND COMMERCIAL RATIONALE OF TRANSFER PRICES

Interface

between the commercial universe and the financial universe. The transfer prices should be in line with both commercial and financial constraints. Transfer prices should also be consistent with market rates. Mispricing is the difference between economic prices and effective pricing. Mispricing is not an error since it is businessdriven.

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Economic Transfer Prices Chapter Chapter 27 27

Economic

transfer prices refer to market prices. Economic benchmark for transfer prices are all-in cost of funds. The all-in cost of funds applies to lending activities and represents the cost of obtaining these funds.

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PRICING SCHEMES

Lending

Activities versus Client

Transaction

Revenues and Pricing

Target

Risk-based Pricing

Calculations

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Lending Activities
Risk-based

pricing is the benchmark & should be purely economic. Commercial pricing refers to mark-ups and mark-downs over economic benchmarks to drive the business polices. To drive the business policies through incentives Effective pricing refers to actual prices used by banks. Mispricing is the difference between effective prices and target prices.

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Transaction versus Client Revenues and Pricing

Risk-based

pricing might not be competitive at the individual transaction level simply Because market spreads are not high enough to price all costs to a large corporate Banks provide products and services and obtain as compensation interest spreads and fees. The overall client revenue is the relevant measure for calculating profitability

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Target Risk-based Pricing Calculations

Components of transfer price.% Cost of debt +Cost of liquidity +Expected losses +Operating costs =Transfer price +Risk-based margin =Target risk-based price +Commercial incentives =Customer rate 7.00 0.20 0.50 0.50 8.20 0.72 8.92 0 8.92
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THE COST OF FUNDS FOR LOANS

The

cost of funds for loans The Cost of Existing Resources The Notional Funding of Assets The Benefits of Notional Funding Transfer Prices for Resources

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TRANSFERRING LIQUIDITY AND INTEREST RATE RISK TO ALM Transfer Pricing

Two

factors help to fully separate commercial and financial risks. First, the commercial margins become independent of the market maturity spread of interest rates. Second, referring to a debt replicating the asset removes the liquidity and the market risks from the commercial margin.

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BENCHMARKS FOR EXCESS RESOURCES

Bank

considers global management of both loan and investment portfolios. Set up an investment policy independently of the loan portfolio The transfer price for the portfolio becomes irrelevant

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Capital Allocation and Risk Chapter Chapter 51 Contributions- 51 The risk contribution
The

risk retained by a facility, or a sub portfolio, post-diversification.

Risk contributions
Absolute

risk contributions (allocation of the portfolio risk to the existing individual or subportfolio facilities) Marginal risk contributions (change in risk with or without an additional unit of exposure)
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DEFINITIONS AND NOTATION

Definitions
The standalone risk The marginal risk contribution The absolute risk contribution

Notation

The portfolio loss is the summation of individual obligor losses. The exposures are Xi , i = 1 to N. Li , i = 1 to N. To make random losses distinct from certain exposures, we use Li for losses and Xi for exposures. The loss volatility is the standard deviation of a loss. The unit exposure loss volatility of a single facility The correlation coefficients between individual losses Li are ij = ji Superscript P is used .
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ABSOLUTE AND MARGINAL RISK CONTRIBUTIONS TO PORTFOLIO LOSS VOLATILITY AND CAPITAL

Risk

Contribution Definitions Properties of Risk Contributions Risk

Basic

Undiversifiable

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THE CAPITAL ALLOCATION MODEL AND ABSOLUTE RISK CONTRIBUTIONS

Portfolio The

Loss Volatility

Absolute Risk Contributions to

Portfolio Loss Volatility

From

Absolute Risk Contributions to

Capital Allocation

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Portfolio Loss Volatility

2P 2P For

= Cov(LP ,LP ) = Cov (Li , Lj )=Cov (Li,LP )

all combinations of i and j, of the ijij terms:2P = ij ij

The

correlation coefficient between the losses of i and j is: ij = Cov(Li , Lj )/ij

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The Absolute Risk Contributions to Portfolio Loss Volatility Transfer Pricing Definition of Absolute Risk Contributions to Volatility : 2P = Cov (LP ,LP ) = Cov (Li , LP) = Cov (Li ,LP ) The loss volatility is P =Cov(Li , LP)/ P ARCP i = Cov(Li ,LP )/P

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The Absolute Risk Contributions to Portfolio Loss Volatility(cont..) Simplified Formulas for Risk Contributions:
To find a simple formula,we first write Cov(Li , LP ) = iP i P . Dividing both terms by P , we find the first simple relation: ARCPi = i P i To find an alternative simple relation, we use the definition of the coefficient i : i = im i/m and i i = im i P as the reference portfolio instead of the market portfolio: ARCPi = iP i = i P

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The Absolute Risk Contributions to Portfolio Loss Volatility(cont..) Risk Contributions Capture Correlation Effects: The absolute risk contributions sum to the loss volatility of the portfolio, a key property that becomes obvious given the definition of ARCPi : ARCPi =Cov(Li , LP )/P = 2P /P = P

ARCPi = P

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Marginal Risk Contributions Chapter 52 Marginal risk contributions

The

changes in risk with and without an additional unit of exposure, a facility or a subportfolio of facilities. pricing based on marginal risk contributions charges to customers a mark-up equal to the risk contribution times the target return on capital.

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THE MARGINAL RISK CONTRIBUTIONS

Marginal

Contributions to Loss

Volatility
The

Marginal Risk Contributions to

Capital
General

Properties of Marginal Risk

Contributions
Implications
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Marginal Contributions to Loss Volatility Transfer Pricing

The

marginal contribution of B to the portfolio loss volatility is the latter minus the loss. The marginal risk contribution of A is determined in the same way. The sum of these marginal risk contributions is 21.05, significantly less than the portfolio loss volatility. We observe that: MRC(LVP) < ARC(LVP) < standalone risk

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The Marginal Risk Contributions to Capital

Capital

derives from the loss distributions and the loss percentiles at various confidence levels. Capital is the loss percentile in excess of expected loss totaling 9.5, or 100 9.5 = 90.5. At a 1% confidence level, leading to a loss percentile of 100 for the portfolio A + B and a capital of 100 9.5 = 90.5. At a 0.5% confidence level would result in a maximum portfolio loss of 150 and a capital of 150 9.5 = 140.5.

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General Properties of Marginal Risk Contributions

The

marginal risk contributions to the portfolio loss volatility are lower than the absolute risk contributions. risk contributions to portfolio capital can be higher or lower than absolute risk contributions to capital.

Marginal

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MARGINAL RISK CONTRIBUTIONS TO VOLATILITY Vs ABSOLUTE RISK CONTRIBUTIONS TO VOLATILITY

Relation between the Marginal and Absolute Risk Contributions

MRCf = P+f P P+f = ARCP+fP + ARCP+f

Marginal versus Absolute Risk Contribution for a New Facility

MRCf < ARCP+ff < f The difference between MRCf and ARCP+ff is (ARCP+fP P )

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MARGINAL RISK CONTRIBUTIONS AND PRICING

Risk-based

Pricing Requires Marginal

Risk Contribution
General The

Formulation

Pricing Paradox with Risk

Contributions

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CAPITAL ALLOCATION VIEW Vs PRICING VIEW

Ex

Ante versus Ex Post Views of Risk and

Return
Capital

Allocation Performance versus Risk-based

Risk-adjusted

Pricing

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Ex Ante versus Ex Post Views of Risk and Return

Ex Ante

Ex Post Absolute Risk Contributions Capital Allocation Risk-adjusted Performance

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Marginal Risk Contributions Risk-based Pricing Pricing Consistent with Target Return

THANKS TO ALL

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