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Incorporating Liquidity Risk into Funds Transfer Pricing: Progress and Challenges

Welcome!. Incorporating Liquidity Risk into Funds Transfer Pricing: Progress and Challenges. Incorporating Liquidity Risk into Funds Transfer Pricing: Progress and Challenges Agenda

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Incorporating Liquidity Risk into Funds Transfer Pricing: Progress and Challenges

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  1. Welcome! Incorporating Liquidity Risk into Funds Transfer Pricing: Progress and Challenges

  2. Incorporating Liquidity Risk into Funds Transfer Pricing: Progress and Challenges Agenda 6.30 – 6.35: Welcome - PRMIA Steering Committee member Donald Lawrence, UCL6.35 – 6.45: Introduction to the day’s event by Vijay 6.45 – 7.30 (flexible): Opening remarks by Kumar (FSA) followed by Arno Commerzbank) 7.30 – 8.00 (flexible): Panel discussion 8.00 (flexible) onwards: Drinks at the Bar and networking

  3. UCL - PRMIA Course A Complete Course in Risk Management 6 – 10 February, 2012, London Day 1: Foundations of Risk Measurement and Risk Finance Theory Day 2: Financial Markets & Instruments; Market Risk Management Day 3: Credit & Operational Risk Management Day 4: Capital Allocation and Liquidity Risk Management Day 5: Crisis Management and Non-Market Risk

  4. Global Risk Conference Save the date! 10th Anniversary PRMIA Global Risk Conference 14th-16th of May 2012 Marriot Marquis, NY Visit www.prmia.org/globalriskconference

  5. Incorporating Liquidity Risk into Funds Transfer Pricing: Progress and Challenges Arno Kratky - Head of Liquidity Analytics, Group Treasury, Commerzbank Kumar Tangri - Risk Specialist, ALM & Liquidity, FSA Vijay Krishnaswamy- Partner and Head of Enterprise Risk Management, Hymans Robertson

  6. FTP regulations: A clear view on the horizon? Kumar Tangri 6

  7. Today’s Agenda • How are regulations incorporating FTP into liquidity management • Will FTP play a larger role in future regulation • Things to look out for

  8. Overriding message • Good Funds Transfer Pricing practice drives sustainablebusiness models. • Messages from Funds Transfer Pricing help develop strategy

  9. Funds Transfer Pricing – what is it? Funds Transfer Pricing (FTP) is the mechanism by which the cost, benefits and risks of liquidity is reflected to a firm’s business lines – i.e. a sophisticated, forward looking pricing model. It is an internal measurement and allocation process that assigns a liquidity risk-adjusted profit contribution value to funds gathered and lent or invested by the firm. FTP is one aspect of full Transfer Pricing, which builds hurdle rates by inclusion of cost of capital (for instance for credit risk).

  10. How are regulations incorporating FTP into liquidity management • BIS - Principles for Sound Liquidity Risk Management and Supervision [Sept 2008] {Principle 4} • FSA – PS09/16, Strengthening Liquidity Standards [October 2009] {BIPRU12.3.15E} {BIPRU12.5.4R} • EBA – CP36 Guidelines on Liquidity Cost Benefit Allocation [March 2010]

  11. How are regulations incorporating FTP into liquidity management • PS09/16, Strengthening Liquidity Standards {BIPRU12.3.15E} States that firms should accurately quantify liquidity costs, benefits and risks for • product pricing • performance measurement and incentives • new product approval Applies to significant business activity – on and off balance sheet Consider FTP in normal and stressed conditions Clear and transparent – needs to be understood across the business 11

  12. How are regulations incorporating FTP into liquidity management • PS09/16, Strengthening Liquidity Standards {BIPRU12.5.4R} Requires firms to include assessment of compliance with BIPRU12.3 and BIPRU12.4 (systems and controls requirements) in the ILAA Compliance influences ILG 12

  13. Will FTP play a larger role in future regulation • Andrew Bailey, Executive Director, Bank of England and Director, UK Banks and Building Societies, FSA - Santander International Banking Conference2009 “fire prevention is better than fire-fighting. We cannot justify having a banking system that depends on the use of public money to douse the fire when the crisis comes. And we also cannot allow conditions to exist where risks are taken on the basis that this backstop exists.” – Santander International Banking Conference 2009 13

  14. Will FTP play a larger role in future regulation • Withdrawal of taxpayer support – whether implicit or explicit • Solo self sufficiency and sustainable business models • Recovery and Resolution Planning • Good Funds Transfer Pricing practice drives sustainablebusiness models. 14

  15. What do and will regulators expect • FSA Dear Treasurer letter on Funds Transfer Pricing (http://www.fsa.gov.uk/pubs/international/ftp_treasurer_letter.pdf) • Benefits and pitfalls Benefits Informs business strategy by identifying the liquidity risk adjusted return from business activities. It helps prevent firms “sleep walking” into business where the true cost of funding is not covered. Contributes to a sustainablebusiness model. Consequence of poor FTP Misallocation of liquidity resource – like capital, liquidity is scarce and needs to be used wisely. Conduct of loss making business or business where reward is not commensurate with risk. 15

  16. What do and will regulators expect • Things to look out for • FTP governance – who owns and challenges the model? Can it be gamed or arbitraged? Is it transparent to stakeholders? Is treasury conflicted? • What components are charged? Is the cost of liquidity buffer recharged? Are all aspects of liquidity risk accounted for?E.g. intra day liquidity, FSCS costs • Is FTP accurate? Does it capture marginal costs? Can it be back tested? Are there un-priced risks? • Approach to back book – does this distort new product pricing?

  17. What do and will regulators expect • Things to look out for • How detailed is FTP? Is it granular enough to influence strategic and day to day transaction decisions?E.g. does it distinguish between asset origination which can be securitised versus assets that can’t? • Does it incentivise appropriate business line behaviours? • SHOULD ENCOURAGE APPROPRIATE INCENTIVES – TO • WRITE AN OPTIMAL BUSINESS MIX • FRAMEWORK SHOULD BE PROPORTIONATE TO FIRMS’ • SCALE AND COMPLEXITY - E.g. Frequency with which prices • are reviewed, frequency of back testing

  18. Funds Transfer Pricing – hurdle rate

  19. What do and will regulators expect FTP practices – marginal costing 19

  20. Funds Transfer Pricing – marginal costing Marginal cost Yield (%) Weighted average cost, back book Time (t) 20

  21. Funds Transfer Pricing – marginal costing • Pros • Correctly captures the cost of doing new business • Cons • Build up of residual unallocated P&L impact due to: • FTP model not accurately reflecting the actual cost of funding which might be incurred, e.g. model charges Libor + 150bp as marginal cost, but actual incurred cost was Libor + 160bp – management overlay, where a deliberate “subsidy” is embedded in pricing to incentivise behaviours, e.g. provide 50bp extra credit for stable retail deposits to incentivise gathering

  22. Funds Transfer Pricing – marginal costing Yield (%) FTP model assumptions Asset Maturity Funding cost ≠ FTP model assumptions Funding tenor ≠ FTP model assumptions Maturity Time (t) Liability Yield (%) Yield (%) Maturity Asset Asset Time (t) Time (t) Liability Liability

  23. Incorporating Liquidity Risk into Funds Transfer Pricing: Progress and ChallengesArno Kratky Group Treasury PRMIA, London January 18th, 2012

  24. Agenda 4. Implications for bank’s steering framework 1. 3. 2. The Regulatory Framework Interplay with Fund Transfer Pricing Interplay with Internal Liquidity Management Framework

  25. The building blocks of Basel III International standard: Basel III BCBS 164 / 189 BCBS 165 / 188 Capital Leverage Ratio Liquidity • Liquidity Coverage Ratio LCR • Buffer to be held against short term liquidity shortages • Net Stable Funding Ratio • effectively limits maturity transformation • Monitoring tools (information only) • contractual maturity mismatch • concentration of funding • unencumbered assets • market-based data • Public disclosure • More and better capital • shift focus to core Tier I capital • excluding hybrid capital • deducting deferred tax assets • minority interests not considered • no Tier III component • Higher RWA • introduce credit value adjustment • account for correlation risk • higher charge on trading books (stress VaR, incremental risk) • increase counterparty risk charge(incentivise central counterparts) • Higher capital ratios • Counter-cyclical capital buffers • Introduction of general • leverage ratio • backstop ratio, not risk-based • nominator is balance sheet total plus (1) off-balance positions, (2) un-netted derivatives, (3) notional of written credit derivatives • denominator given by regulatory Tier I capital • broadly in line with IFRS accounting European implementation: CRD 4 BCBS 189: Strengthening the resilience of the banking sector; BCBS 188: International framework for liquidity risk measurement, standards and monitoring

  26. Understanding the Regulator‘s Perspective of Basel III in a Nutshell Cash markets are fragile and can disappear quickly Too much maturity transformation is unhealthy for the financial system Interconnected financial sectors can collapse like a house of cards There is good banking business (loans, deposits, service real economy) There is bad banking business (prop trading, derivatives, casino)

  27. Liquidity Coverage Ratio / Liquidity Factors Impact on different product types on identical balance sheets: assets assets 50 Government Bond Buffer 50 50 Government Bond Buffer 201) 50 ABS Bond (illiquid) Buffer 0 50 ABS Bond (illiquid) Buffer 0 1) Only 20 units unencumbered since 30 funded via repo but liabilities liabilities Outflow 30 30 one week repo on ABS Bond 30 one week repo on Government Bond Outflow 0 LCR 83% LCR 1000% 30 O/N IB MM Outflow 30 30 3-months IB MM Outflow 0 40 3 months retail (stable) Outflow 0 40 O/N retail (stable) Outflow 2 No credit for short term secured funding of illiquid securities No credit for short term wholesale (interbank) funding

  28. Net Stable Funding Ratio / Liquidity Factors Demonstration of the impact on different products and trading strategies: Liabilities Liabilities 3 Mon. CP non-financial 9 Mon. Repo ASF 50% ASF 0% NSFR 250% NSFR 0% Assets Assets Corporate Bond AA Corporate Bond AA RSF 20% RSF 20% Assets Assets 9-months loan to Hedge Fund RSF 0% Listed Equity RSF 50% Assets Assets 3y Corp. Bond A+funded via 6m Repo 6m Reverse Repo on 3y Corp. Bond A+ RSF 50% RSF 0% 2y Reverse Repo on Government Bond RSF 100% RSF 5% 5y Government Bond Assets Assets Unencumbered mortgage loan Basel II KSA 35% >1y (independent on maturity) Mortgage loan > 1y in covered pool funded by Covered Bond RSF 100% RSF 65% + Overcollateralisation for target rating

  29. Liquidity Implications Non-Operational Corporate Deposits Interplay between LCR and NSFR for non-operational corporate deposits and (short-term) corporate loans (1) Assets Liabilities 100m Non-op. Corporate Deposit Buffer (LCR) 100% => 75m 75m Level 1 Asset Outflow (LCR) 75% => 75m 5% => 3,75m RSF (NSFR) Remaining Cash 25m 25m Term Loan 100% => 25m RSF (NSFR) 50% => 50m ASF (NSFR) => 100m corporate deposits fund 25m term loans 50 75 = 174% NSFR = = 100% LCR = 28,75 75 Though there is headroom in the NSFR, the bank can not lend more (in cash) due to LCR restriction Buying Level 1 assets for the buffer itself generate an additional NSFR requirement

  30. Liquidity Implications Non-Operational Corporate Deposits Interplay between LCR and NSFR for non-operational corporate deposits and (short-term) corporate loans (2) Assets Liabilities 100m Non-op. Corporate Deposit Buffer (LCR) 100% => 75m 75m Level 1 Asset Outflow (LCR) 75% => 75m 5% => 3,75m RSF (NSFR) Remaining Cash 25m 46,25m Term Loan 100% => 46,25m RSF (NSFR) 50% => 50m ASF (NSFR) => 100m corporate deposits fund 46,25m term loans 21.25m short term wholesale > 30d 50 75 = 100% NSFR = = 100% LCR = Outflow (LCR) 0% => 0m 50 75 Extra cash 21.25m In order to use the NSFR ‘capacity’ the bank has to extend its balance sheet and borrow another 21m > 30days at extra costs, which also may compromise the bank’s liquidity ratio (and bank levy)

  31. Inefficient Liquidity Transfer within the Banking System (1/3) Bank A Bank B Cash 5 LCR Buffer (100%) = 5 Retail Loan 100 RSF(85%) = 85 Equity 5 ASF(100%) 5 Stable Deposits 100 ASF(90%) = 90 LCR outflow (5%) = 5 Cash 5 LCR Buffer (100%) = 5 Equity 5 ASF(100%) 5 1 Bank B borrowing funds via stable deposits (<1yr) and lending on term to retail customers (<1yr, but no inflows < 30days). Bank A just holds cash. Bank A Bank B LCR > 100% 100% NSFR > 100% 112%

  32. Inefficient Liquidity Transfer within the Banking System (2/3) Bank A Bank B Cash 10 LCR Buffer (100%) = 10 Loan to FI > 1yr 95 RSF(100%) = 95 Equity 5 ASF (100%) 5 Stable Deposits 100ASF(90%) = 90 LCR outflow (5%)= 5 Equity 5 ASF (100%) 5 Deposit from FI > 1yr 95 ASF(100%) = 95 Cash 0 LCR Buffer (100%) = 0 Retail Loan 100 RSF(85%) = 85 2 Liquidity Transfer of 95 Bank B may transfer liquidity within the banking sector to Bank A via a long-term money market loan. Bank A invests the proceeds into the same portfolio of retail loans as before. RSF for Bank’s B loans increases from 85% to 100%, hence it can only lend 95 to Bank A (Bank B holds the balance in cash and hence increases its buffer). Using its cash balance of 5, Bank A can lend 100 to the private sector. Bank A Bank B LCR > 100% 200% NSFR 118% 100%

  33. Inefficient Liquidity Transfer within the Banking System (3/3) Bank A Bank B Cash 10 LCR Buffer (100%) = 10 Loan to FI < 1yr 95 RSF(100%) = 0 Equity 5 ASF (100%) 5 Stable Deposits 100ASF(90%) = 90 LCR outflow (5%) = 5 Cash 0 LCR Buffer (100%) = 0 Retail Loan 100 RSF(85%) = 85 Equity 5 ASF (100%) 5 Deposit from FI < 1yr 95 ASF(0%) = 0 3 When the remaining maturity of the liquidity transfer runs below one year, the efficiency of the liquidity allocation gets impaired. Though the external economic position from the banking sector to the private sector remains unchanged, Bank A would now be required to take additional term funding to comply with the NSFR (inflating its balance sheet) passing on additional costs to its clients or has to withdraw its loans to its customers. Bank A Bank B LCR > 100% 200% NSFR 6% >> 100%

  34. Basel III – Commerzbank‘s Contribution to the Industry Dialogue Participation in Industry working groups Commerzbank plays an active role in liquidity working groups in various banking associations and bilateral discussions with aligned banks as well as with national regulators Banking Associations Aligned Banks Regulatory Authorities …and others…

  35. Agenda 4. Implications for bank’s steering framework 1. 3. 2. The Regulatory Framework Interplay with Fund Transfer Pricing Interplay with Internal Liquidity Management Framework

  36. Increasing Complexity Regulation is a moving target and subject to substantial changes Cumulative effects of regulation and associated (unintended) consequences on markets and banks business models are not well understood Regulatory (minimum) requirements will become more binding and need to be actively managed Ratios can not be seen in isolation but need to be managed simultaneously as ratios are interlinked. Measures which are positive for one ratio can turn out to have negative outcomes for another Banks are left with only little flexibility to manage cumulative effects effectively and to manage liquidity efficiently New regulations lead to alignment of liquidity management frameworks across banks which may result in more rather than less systemic risk

  37. Main Differences between Regulatory and Industry Approach Commerzbank SFR Commerzbank SFR Commerzbank SFR Commerzbank SFR Industry Approach **) Regulatory Approach *) Operational Liquidity Management Liquidity Coverage Ratio (LCR) • Continuous observation period up to 12 months • Representation of cash flow over whole period • Wider definition of liquid assets • Consideration of central bank eligibility • Consideration of interbank funding potential • Decomposition into legal cashflows, behaviouraladjustments and liquidity capacity • Allows for different scenario calculation • Measure expressed as surplus • Observation period 30 days • 30 days point-in-time cumulative cash flow • Narrow definition of liquid assets (no financials) • Focus on secondary market liquidity • No roll-over assumption for interbank funding • Monoblock measure • Only combined stress scenario • Measure expressed as ratio Short term Structural Liquidity Management Net Stable Funding Ratio (NSFR) • Less severe scenario w/o need for CM funding • Target corridor instead of strict limits • Assets and liabilities differentiated by product type and business owner • Less liquid securities funded on haircut • Core loan business requires stable funding • Matched funded structures considered • Contingent liquidity considered in stress portfolio • Covered bonds (self-issued) considered (partly) as stable funding also if remaining maturity < 1 year. • Severe Stress scenario • Minimum ratio 100% permanent • Assets and liabilities differentiated by type of customer and relationship • All securities require stable funding (haircut) • Loan business funded as per roll-over fiction • Matched funded structures not considered • Contingent liquidity require stable funding • Covered bonds (self-issued) not considered as stable funding if remaining maturity < 1 year, covered pool still attracts RSF Long Term *) BCBS 188 as of December 2010 **) Observed methodology across firms

  38. Does Basel III overrule internal fund transfer pricing ? Internal treatmentmore conservative than BIII Internal treatmentmore aggressive than BIII Internal treatmentconsistent with BIII  ()  • Only little impact on running business • The least need for adjustment • Is internal treatment still competitive ? • Will change of internal treatment be challenged by supervisor ? • Regulatory liquidity requirement need to be ‘subsidized’ by other products • Business in danger of being unprofitable • How to migrate to regulatory compliance ?

  39. Does Basel III overrule Internal Funds Transfer Pricing ? Compliance of external and internal requirements on aggregate level   Basel III Internal operational LCR Steering Independent   structural NSFR Less complex, but steering in case of breaches less efficient

  40. Does Basel III overrule Internal Funds Transfer Pricing ? Compliance of external and internal requirements on product level  Internal Assets Basel III Assets  Loans Loans  Deposits Deposits  Facilities Facilities . . . . . .  others others External requirements have significant influence but steering mechanism is synchronized

  41. Agenda 4. Implications for bank’s steering framework 1. 3. 2. The Regulatory Framework Interplay with Fund Transfer Pricing Interplay with Internal Liquidity Management Framework

  42. Integrated Steering Framework Basel III will influence internal processes, but is neither a blue-print for an internal steering system nor for an internal (liquidity) funds transfer price system

  43. Does Basel III overrule internal fund transfer pricing ? Major banks employ a liquidity management system and fund transfer pricing methodology similar to Basel 3 but which differ with regard to parameters. How does a bank cobe with the difference? Working example (asset vs asset): Balance Sheet Volume RSF / internal requirement Ratio met at overall levelbut triggered by different productsLoans -> ‚too expensive‘Facilities -> ‚too cheap‘ 50% 100% 100m Corporate Loan 100m 50m 1bn Credit Facility 50m 100m 5% 0% 50m InternalSF Basel IIINSFR 50m InternalRequirement Basel IIINSFR Options to deal with: 1. Treat Basel III / FTP separately -> two steering mechanism to follow2. Only adobt induced regulatory ‚minimum‘ requirement -> conservative / expensive but aligned on product level 3. Adjust FTP towards regulatory framework -> most consistent alignment, abandonment of own economic assessment, could be challenged by regulator

  44. How to adopt Basel III to internal fund transfer pricing ? Banks need to set steering signals to their trading units to manage restructuring of balance sheets. Timing is an important component. How fast should banks implement Basel 3 rules in FTP? Working example: Funding of a financial bond Currently, banks fund financials short term as they are tradable in financial markets. However, Basel 3 requires term funding latest by 2018. Banks have to adust their funding accordingly: FTP(in bps) FTP(in bps) FTP(in bps) 3 2 1 Time 2018 2018 2018 2011 2011 2011 Options: 1. Keep current FTP and adjust as late as possible -> inappropriate adjustment to Basel 32. Adjust FTP immediately for anticipated B 3 funding costs -> triggering of unintended consequences?3. Phase-in higher charges over time and signal to the trading desks -> proportional migration to reg. environment

  45. Agenda 4. Implications for bank’s steering framework 1. 3. 2. The Regulatory Framework Interplay with Fund Transfer Pricing Interplay with Internal Liquidity Management Framework

  46. Where the Business is affected Understand mechanics of Basel III and implications on business model Analyze portfolio mix and identify which products will have different treatment under regulatory rules compared to current internal treatment Consider potential pricing implications on anchor products (PK: retail loans & deposits, MSB: corporate loan book, C&M: trading portfolio, matched book, equity financing, ABF: secured financing) Understand need of customers and potential implication for end-users (to facilitate dialog with supervisors) Monitor competitors and their potential adjustments to product mix and/or pricing behavior Assess potential to pass on additional costs or anticipate structural changes to product mix Think about product innovation (but be aware of reputational limitation to exercise optionality)

  47. Behavioral Adaption to NSFR NSFR Isolines • Potential Adjustments on Business Model • compress net position of derivatives • cut credit lines • focus on advisory business • revival of ‚originate and distribute‘ model > 100% = 100% ASF < 100% ImprovingNSFR 1 NSFR ASF NSFR = 2 RSF RSF To improve a given NSFR (indicated by in the chart above) an institution has two options: • Adjust Asset Side • reduce maturities • shift to assets with lower RSF • Adjust Liability Side • increase maturities • shift to liabilities with higher ASF • The institution can increase the ASF by adjusting the liability side of ist balance sheet (e.g. liabilities with higher roll-over factors or longer duration) • The institution can decrease the RSF by adjusting the asset side of ist balance sheet (e.g. assets with lower roll-over factors or shorter duration) impact oncosts  impact onearnings 

  48. Potential Steering Measures to Manage the LCR Liquidity buffer LCR = (Cash outflow – Cash inflowcap 75%) ≤ 30d Levers to manage the ratio: Increase Cash inflow (-> lower returns) Decrease Cash outflow (-> lower returns) Increase Liquidity buffer (-> higher costs) Hold more Cash Increase duration of liabilites (e.g. short term deposits) Decrease duration of assets (e.g. short term loans) Sell illiquid assets and buy level 1/2 assets Increase stability of deposits (e.g. stable retail deposits and wholesale operational accounts) Decrease potencial liquidity drains (credit/ liquidity facilities)

  49. Potential Steering Measures to Manage the NSFR Available Stable Funding (ASF) NSFR = Required Stable Funding (RSF) In principle, the bank has two levers to manage the ratio: Decrease RSF (-> lower returns) Increase ASF (-> higher costs) Securitize existing business which is already term funded (and keep existing funding) Sell (non-level 1/2) assets Substitute assets with longer duration (>1yr) by assets with shorter duration (<1y) Substitute liabilities with short duration (<1y) by liabilities with longer duration (>1yr) Substitute assets with high RSF (illiquid bonds, term loans, retail loans) by assets with lower RSF (0%-risk weight govies, short term loans to financial institutions) Substitute liabilities with low ASF (wholesale) by liabilities with higher ASF (retail) Originate new liabilities (and invest cash into assets with lower RSF) New asset business does not improve the ratio

  50. Regulatory Requirements – More than a Compulsory Excercise Liquidity requirements such as LCR and NSFR, as currently stipulated by known drafts of Basel III and CRD IV, respectively, will have much more significance for liquidity management and steering due to their pronounced stress-orientated design, which is more demanding than current national regulatory liquidity requirements in place Forthcoming regulation will not allow for an escape clause, allowing institution to apply internal liquidity models for regulatory reporting purposes instead of standardised external rules. Hence, liquidity regulation becomes instantaneous binding once they become effective. At the same time, financial markets evidence tightening liquidity situation expressed in terms of volatility, increasing liquidity premia and restraint liquidity supply, both in volume and tenor. The combination of increasing regulatory (minimum-) requirements and increasing liquidity costs necessitate an efficient management and steering of liquidity in order to achieve an optimal level of compliance and to avoid extra-ordinary liquidity buffers and associated costs.

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