Re-evaluating Funds Transfer Pricing best practices: Is it still working effectively?

Beata Lubinska
Faculty, Banking Treasury Risk Management (BTRM)

The introduction of Basel III liquidity metrics Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) has introduced more complexity into the Funds Transfer Pricing framework. The methodology on how to embed these costs into it remains an open issue for many banks. There are no regulatory guidelines in this respect nor one universal best practice in the market. Consequently, banks need to do their homework and to revamp their Funds Transfer Pricing methodology accordingly. This challenge creates an opportunity for banks to enhance their Funds Transfer Pricing framework to incorporate regulatory costs as part of an integrated approach and to grow the right balance sheet in an increasingly regulated external environment. 

The overall objectives of such an exercise are to construct a framework that is better defined, simple to understand, makes internal drivers of the bank’s Net Interest Margin (NIM) more transparent and less volatile, and appropriately consider regulatory liquidity costs.

One of the main challenges of the inclusion of LCR and NSFR requirements into the Funds Transfer Pricing framework consists of the fact that banks have stress test metrics and scenarios for liquidity already included in Funds Transfer Pricing. So it’s necessary to align those metrics with LCR in the first place.

There are three main enhancements which need to be made on the existing Funds Transfer Pricing framework to align the model with Basel III:

  1. Introduce precise and integrated regulatory and internal stress views, for example, LCR and short-term liquidity metrics;
  2. Embed the NSFR cost into the Funds Transfer Pricing framework;
  3. Establish an internal price that combines the transference of liquidity and interest rate risk as well as an allocation of cost arising from liquidity regulation.

With these enhancements, the new Funds Transfer Pricing framework will provide transparency on how internal rates are applied and allow banks to see its all-in cost of funding and offer greater visibility over its NIM. One way to achieve this is through the application of liquidity profiling which aims to capture the stress liquidity assumptions and liquidity behavioural assumption for various products and client segments.

Funds Transfer Pricing profiling is a methodology which attempts to capture the full interest rate risk and liquidity cost/value of the product. The correct transference of interest rate risk and liquidity risk from ALM to business units is especially important for profit allocation within the bank as it directly influences business line activities. If funding costs are underestimated, business lines may offer customers cheaper loans and increase funding volumes in the mistaken belief that they are profitable. If funding costs are overestimated, business lines may mistakenly require higher customer rates to be perceived as profitable.

One example of profiling is to maintain a clear division between the stress test and the stable liquidity balance.

Stress liquidity assumptions will be adopted from either internal stress liquidity risk view or the regulatory view. The internal stress liquidity risk view is based on a bank’s internal stress testing Survival Horizon[1], which models combined (name specific and market-wide) stress scenario for a period of, for example, two months. The regulatory view will be referring to Basel III LCR assumptions or local regulatory requirements for 30 days stress. In this approach, the guiding principle is to use the more binding metric between the internal stress liquidity risk view and regulatory view. It applies at the country, product, client or segment level and depends on the availability of sufficiently granular data.

The interest rate risk view would then overlay any liquidity profiling. This adds to the complexity of the picture, especially once pricing of non-maturing products is taken into account.

The resulting blended rate reflects either assumption from the IRR and liquidity perspective.

It is essential to keep in mind challenges faced by ALM/ treasury in light of the LCR and NSFR requirements as the recognition of these additional costs, resulting from the implementation of the new regulatory expectations, is imperative for the more sophisticated Funds Transfer Pricing framework. For many banks, the question of how to integrate the cost to comply with LCR and NSFR ratios into Funds Transfer Pricing remains an open issue. Funds Transfer Pricing profiling represents one possible solution which can be adopted to solve the problem.

To learn more, feel free to message me to explore more, or have a conversation.

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[1] Survival Horizon is the term to reflect the duration of the stress conditions in liquidity stress testing framework.

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