In the wake of the financial crisis, the UK FSA reviewed bank liquidity policies. Its proposals are not final but it is apparent that banks will have to operate under a more stringent liquidity risk management regime. Although comprehensive, the FSA review does not address the issue of internal bank funds pricing. Fund transfer pricing is a key issue.
Liquidity and risk management
Recent FSA proposals on the future of bank regulation emphasised inter alia a more controlled approach to bank liquidity risk management. Features of the new regime include:
– increased self-sufficiency in funding;
– a more diversified funding base;
– longer average tenor of liabilities,
– a “liquidity buffer” of high quality government securities.
These recommendations should be welcomed, and should be seen as part of a wholesale shift in the basic banking model, which hitherto had relied excessively on short-term and wholesale, undiversified funding. However, the FSA proposals do not address another critical issue in banking operations: how funds are managed internally. In truth, how banks structure their internal fund 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.
We define liquidity risk as being unable to (i) raise funds to meet payment obligations as they fall due and (ii) fund an increase in assets. Funding risk is the risk of being unable to borrow funds in the market. The FSA-prescribed mechanism to mitigate liquidity and funding risk is notable for its focus on the type, tenor, source and availability of funding, exercised in different market conditions.This emphasis on liquidity is correct, and an example of a return to the roots of banking. While capital ratios are a necessary part of bank risk management, they are not sufficient.
Northern Rock and Bradford & Bingley were more a failure of liquidity management than capital erosion. It is not surprising that there is now a strong focus on the extraneous considerations to funding. However the use of that funding, including the price at which cash is internally lent or transferred to business lines, has not been closely scrutinised. This needs to be addressed by regulators as it is a driver of bank business models, which were shown to be flawed and based on inaccurate assumptions during 2007 and 2008.
Internal framework
While the FSA does touch on bank internal liquidity pricing, the coverage is peripheral. This is unfortunate, because it is a key element behind the model. Essentially, the price at which an individual bank business line raises funding from its Treasury desk is a major parameter in decision making, driving sales, asset allocation, and product pricing. It is also a key hurdle rate behind the product approval process and in individual line performance measurement. Just as capital allocation decisions affecting front office business units need to account for the cost of that capital, so funding decisions exercised by corporate treasurers carry significant implications for sales and trading teams at the trade level.
The price at which cash is internally transferred within a bank should reflect the true economic cost of that cash (at each maturity band), and its impact on overall bank liquidity. This would ensure that each business aligns the commercial propensity to maximise profit with the correct maturity profile of associated funding. From a liquidity point of view, any mismatch between the asset tenor and funding tenor, after taking into account the “repo-ability” of each asset class in question, should be highlighted and acted upon as a matter of priority, with the objective to reduce recourse to short term, passive funding as much as possible. It is equally important that the internal funding framework is transparent to all trading groups. A measure of discipline in decision-making is enforced via the imposition of minimum return-on-capital (ROC) targets. Independent of the internal cost of funds, a business line would ordinarily seek to ensure that any transaction it entered into achieved its targeted ROC. However, relying solely on this measure is not always sufficient discipline. For this to work, each business line should be set ROC levels that are commensurate with its (risk-adjusted) risk-reward profile. However, banks do not always set different target ROCs for each business line, which means that the required discipline breaks down. Second, a uniform cost of funds, even allowing for different ROCs, will mean that the different liquidity stresses created by different types of asset are not addressed adequately at the aggregate funding level. Consider the following asset types:
– a 3-month interbank loan;
– a 3-year floating rate corporate loan, fixing quarterly;
– a 3-year floating-rate corporate loan, fixing weekly;
– a 3-year fixed-rate loan;
– a 10-year floating-rate corporate loan fixing monthly;
– a 15-year floating-rate project finance loan fixing quarterly.
We have selected these asset types deliberately, to demonstrate the different liquidity pressures that each places on the Treasury funding desk (listed in increasing amount of funding rollover risk). Even allowing for different credit risk exposures and capital risk weights, the impact on the liability funding desk is different for each asset. We see then the importance of applying a structurally sound transfer pricing policy, dependent on the type of business line being funded.
Cost of funds
As a key driver of the economic decision-making process, the cost at which funds are lent from central Treasury to the bank’s businesses needs to be set at a rate that reflects the true liquidity risk position of each business line. If it is unrealistic, there is a risk that transactions are entered into that produce an unrealistic profit. This profit will reflect the artificial funding gain, rather than the true economic value-added of the business.
There is evidence of the damage that can be caused by low transfer pricing. Adrian Blundell-Wignall and Paul Atkinson in a 2007 report for the OECD discuss the losses at UBS AG in its structured credit business, which originated and invested in collateralised debt obligations (CDO). Quoting a UBS shareholder report,
“…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).”
UBS structured credit business was able to fund itself at prices better than in the market (which is implicitly inter-bank risk), despite the fact that it was investing in assets of considerably lower liquidity than inter-bank risk. There was no adjustment for tenor mismatch, to better align term funding to liquidity. A more realistic funding model was viewed as a “constraint on the growth strategy”.
This lack of funding discipline undoubtedly played an important role in decision making, because it allowed the desk to report inflated profits based on low funding costs. As a stand-alone business, a CDO investor would not expect to raise funds at sub-Libor, but rather at significantly over Libor. By receiving this artificial low pricing, the desk could report super profits and very high return-on-capital, which encouraged more and more risky investment decisions.
Another example involved banks that entered into the “fund derivatives” business. This was lending to investors in hedge funds via a leveraged structured product. These instruments were illiquid, with maturities of two years or longer. Once dealt, they could not be unwound, thus creating significant liquidity stress for the lender.
However, banks funded these business lines from central Treasury at Libor-flat, rolling short term. The liquidity problems that resulted became apparent during the 2007-2008 financial crisis, when interbank liquidity dried up.
Many banks operate on a similar model, with a fixed internal funding rate of Libor plus (say) 15 bps for all business lines, and for any tenor. But such an approach does not take into account the differing risk-reward and liquidity profiles of the businesses.
The corporate lending desk will create different liquidity risk exposures for the bank compared to the CDO desk or the project finance desk. For the most efficient capital allocation, banks should adjust the basic internal transfer price for the resulting liquidity risk exposure of the business. Otherwise they run the risk of excessive risk taking heavily influenced by an artificial funding gain.
Conclusions
It is important that the regulatory authorities review the internal funding structure in place at the banks they supervise. An artificially low funding rate can create as much potentially un-manageable risk exposure as an risk-seeking loan origination culture. A regulatory requirement to impose a realistic internal funding arrangement will mitigate this risk.
We recommend the following approach:
– a spread over the internal transfer price, based on the median credit risk of the individual business line. This would be analogous to the way the Sharpe ratio is used to adjust returns based on relative volatility. It would also allow for the different risk-reward profiles of different asset classes;
– a fixed add-on spread over Libor for term loans or assets over a certain maturity, say two years, where the coupon re-fix is frequent (such as weekly or monthly), to compensate for the liquidity mismatch. The spread would be on a sliding scale for longer term assets.
Internal funding discipline is as pertinent to bank risk management as capital buffers and effective liquidity management discipline.
As banks adjust to the new liquidity requirements soon to be imposed by the FSA, it is worth them looking beyond the literal scope of the new supervisory fiat to consider the internal determinants of an efficient, cost effective funding regime. In this way they can move towards the heart of this proposition, which is to embed true funding cost into business-line decision-making.
Dr Moorad Choudhry is Head of Treasury at Europe Arab Bank, and author of Bank Asset and Liability Management (John Wiley & Sons)
