Risk and Funds Transfer Pricing

Assuming the risk measures to be adopted are specified, how would you proceed to allocate them to different department of the Organization?

A Bank may pursue an income rate risk strategy of organizing its cash flows so as to generate cash to its shareholders in a similar manner as a sequential investment in (say) a three month treasury bill would do. This investment would be turned over in three monthly cycles. In this type of scenario, the bank income rises and falls keeping in line with the market interest rate fluctuations. This will however not affect the stock price of the bank which will remain stable and never reach zero. As such, the bank is in no risk of going bankrupt.

An alternative strategy that the bank may exercise comprises of locking its net income at a fixed level equal to the coupon rate of a 30 year treasury bond. In this case, the bank stock price may stay volatile while its net income remains unchanged. However, here too, since the bank’s stock price will never close in on zero, any risk of the bank becoming bankrupt does not arise.

In both scenarios above, the argument that the bank’s stock rate will never reach zero can be compared to the status of a three month treasury bill in the first case, and that of a 30 year treasury bond in the second case, both of which will never register zero value.

Further, banks should define their risk levels in such a way that their risks would not stray beyond the interest rate risk safety zones. This implies that their settings of risk limits would ensure that –

(a)     The market value of portfolio equity at any rate of interest would never reach a negative value, or

(b)     The annual cash flow at any rate of interest too would never reach a negative value.

Achieving the above objectives would entail setting goals with proper planning and at a reasonable level of periodical review. Some of the tools that can be effectively used in the case of (a), would quantify the risk limit through the use of calculations aimed at ascertaining the market value of equity portfolio sensitivity and value at risk. In the case of (b), net income simulation may be used as a proxy.

It is also to be noted that –

•  Two parties with similar experience and skills should establish similar risk limits. E.g. a trader on the trading floor and a person running the transfer pricing book.
• Risk limits for the transfer pricing book should provide adequate leverage for hedging to be undertaken.
• Bulk of the risk in a large organization should not only be allocated very clearly to senior management, but also be split for its unambiguous allocation.

Treatment of the Transfer Pricing Book as a Separate Portfolio:

 

Given that the under mentioned alternative possibilities exist with regard to the Transfer Pricing Book, what course of action would you recommend?

The two available alternative methodologies are as follows:

(i)      The T/P book to be demarcated separately.

(ii)      The said book to be included under “other categories” of risks that have not been allocated to a specific unit except the ALCO.

Unfortunately, there is no consistency in the internal policies adopted by different institutions with regard to transfer pricing. Loan Officers in a majority of large banks are required to obtain real time cost of funds quotes for loans over a specified limit, usually fixed at US$1 million. This requirement is enforced to keep room for hedging the transactions in real time. However, failure on the part of some institutions to segregate the transfer pricing portfolio for its identification as a separate portfolio under a specific manager has given rise to a situation where getting real time cost of funds quotes is being avoided by issuing loans just below the set limit of US$1 million. As a result, many loans go un-hedged.  Consequently, the aggregate of such “medium size” loans is seen too far to exceed the aggregate of loans of US$1 million and over. This brings us to the question as to what purpose is served by insisting on match-funding for some loans only, instead of all.

In view of above, the recommendation is that the transfer pricing book be managed subject to following procedures:

• Manager of the book to be identified by name. His main duty shall be its hedging.
• A mark-to-market basis to be adopted for hedging in preference to a basis of net income simulation.
• Exposure to Risk to be evaluated and reported to the senior manager concerned daily.
• Risk factor of the transfer pricing book to review by ALCO at very meeting.
• Numerical risk limits to be officially set on the transfer pricing book.
• ALCO to be notified in writing of all cases of risk limit violations, while taking prompt corrective action simultaneously.