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Chapter 26Chapter 26

Tools for risk management

1.The Funds Transfer Pricing system (allocate interest

income)2.The capital allocation system (allocate risks)

Transfer prices serve as reference rates for

calculating interest income of transactions, productlines, market segments and business units.

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Fund Transfer Pricing Systems-Chapter 26

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Transferring funds between units.

Breaking down interest income by transaction or anysubportfolio such as business units.

Setting target profitability for business units.

Transferring interest rate risk to ALM.

Pricing funds to business units with economicbenchmarks.

Combining economic prices with commercial

incentives.

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The FTP System Specifications

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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.

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The Goals of The Transfer Pricing System

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Funds Transfer Pricing system and itsapplications.

5

Define economicbenchmarks

Measureperformance

Allocate funds

Pricing

FundTransfer

Pricingsystem

Economictransferprices

Transfer risks toALM

Funds Transfer Pricing

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1. ALM, Treasury and Management Control(Unit in charge of managing the liquidity &interest rate exposure of the bank)

2. Internal Pools of Funds (virtual location

where all funds ,excesses & deficits arecentralized)

a. Netting

b. Pricing all Outstanding Balances

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INTERNAL MANAGEMENT OF FUNDS AND NETTING

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The central pool of all assets and liabilities

8

Market

Centralpooling of

net

balances

Business unitA

Business unitB

Purchase of

allresources

Sale of all usesof funds

Sale of all uses

of funds

Purchase of

all resources

Pricing all Outstanding Balances TransferPricing

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The commercial marginSpread between customer

prices and internal prices.

The financial marginVolumes exchanged + the

spreads between internal pricesand the market prices used toborrower invest.

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MEASURING PERFORMANCE

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For the bank .Sum all revenues and costs fromlending and borrowing.

For the business units.

Revenues result from customer prices(-) the cost of any internal purchase ofresources by the central unit.

For the ALM unit.

Revenues result from charging the

lending units the cost of their funds.

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MEASURING PERFORMANCE

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ALM Profitability and Risks

Setting Target Commercial Margins

Mbank = Mcommercial +MALM

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ALM AND BUSINESS UNIT PROFITABILITY GOALS

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Policies and profitability of ALM

12

ALMP&L

Maintainrisk within

limits

Minimizefunding cost

Maximizeinvestment

return

Return

Risks

Setting Target Commercial Margins

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Interface between the commercial universeand the financial universe.

The transfer prices should be in line with bothcommercial and financial constraints.

Transfer prices should also be consistent withmarket rates.

Mispricing is the difference betweeneconomic prices and effective pricing.

Mispricing is not an error since it is business-driven.

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THE FINANCIAL AND COMMERCIAL RATIONALEOF TRANSFER PRICES

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Economic transfer prices refer tomarket prices.

Economic benchmark for transfer

prices are all-in cost of funds.The all-in cost of funds applies to

lending activities and represents thecost of obtaining these funds.

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Economic Transfer Prices Chapter27

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Lending Activities

Transaction versus Client

Revenues and Pricing

Target Risk-based Pricing

Calculations

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PRICING SCHEMES

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Risk-based pricing is the benchmark & shouldbe purely economic.

Commercial pricing refers to mark-ups andmark-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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Lending Activities

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Risk-based pricing might not be competitiveat the individual transaction level simply

Because market spreads are not high enoughto price all costs to a large corporate

Banks provide products and services andobtain as compensation interest spreads andfees.

The overall client revenue is the relevant

measure for calculating profitability

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Transaction versus Client Revenues andPricing

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Components of transfer price.%

Cost of debt 7.00

+Cost of liquidity 0.20

+Expected losses 0.50

+Operating costs 0.50

=Transfer price 8.20

+Risk-based margin 0.72=Target risk-based price 8.92

+Commercial incentives 0

=Customer rate 8.92

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Target Risk-based Pricing Calculations

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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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THE COST OF FUNDS FOR LOANS

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Two factors help to fully separate commercialand financial risks.

First, the commercial margins become

independent of the market maturity spread ofinterest rates.

Second, referring to a debt replicating theasset removes the liquidity and the market

risks from the commercial margin.

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TRANSFERRING LIQUIDITY AND INTEREST RATE RISKTO ALM Transfer Pricing

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Bank considers global management of bothloan and investment portfolios.

Set up an investment policy independently ofthe loan portfolio

The transfer price for the portfolio becomesirrelevant

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BENCHMARKS FOR EXCESS RESOURCES

C i l All i d Ri k

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The risk contributionThe risk retained by a facility, or a sub

portfolio, post-diversification.

Risk contributionsAbsolute 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 ofexposure)

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Capital Allocation and RiskContributions- Chapter 51

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DefinitionsThe standalone riskThe marginal risk contributionThe 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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DEFINITIONS AND NOTATION

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Risk Contribution Definitions

Basic Properties of Risk Contributions

Undiversifiable Risk

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ABSOLUTE AND MARGINAL RISK CONTRIBUTIONS TOPORTFOLIO LOSS VOLATILITY AND CAPITAL

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Portfolio Loss Volatility

The Absolute Risk Contributions to


From Absolute Risk Contributions to

Capital Allocation

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THE CAPITAL ALLOCATION MODEL AND ABSOLUTE RISKCONTRIBUTIONS

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2P = Cov(LP,LP )

2P = Cov (Li, Lj )=Cov (Li,LP)

For all combinations of i and j, of the ijij

terms:

2

P = ij ijThe correlation coefficient between the losses

of i and j is:

ij = Cov(L i , Lj)/ij

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Definition of Absolute Risk Contributionsto 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 LossVolatility Transfer Pricing

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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 = iP iTo 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 PortfolioLoss Volatility(cont..)

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Risk Contributions Capture CorrelationEffects:

The absolute risk contributions sum to theloss volatility of the portfolio, a key propertythat becomes obvious given the definition ofARCPi :

ARCPi =Cov(Li, LP)/P = 2P /P = P

ARCPi = P

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The Absolute Risk Contributions to PortfolioLoss Volatility(cont..)

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Marginal risk contributionsThe changes in risk with and without an

additional unit of exposure, a facility or asubportfolio of facilities.

pricing based on marginal risk contributionscharges to customers a mark-up equal to therisk contribution times the target return oncapital.

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Marginal Risk Contributions Chapter 52

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Marginal Contributions to Loss

Volatility

The Marginal Risk Contributions to

Capital

General Properties of Marginal Risk

Contributions

Implications

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THE MARGINAL RISK CONTRIBUTIONS

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The marginal contribution of B to the portfolioloss volatility is the latter minus the loss.

The marginal risk contribution of A isdetermined in the same way.

The sum of these marginal risk contributionsis 21.05, significantly less than the portfolioloss volatility.

We observe that:

MRC(LVP) < ARC(LVP) < standalone risk

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Marginal Contributions to Loss VolatilityTransfer Pricing

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Capital derives from the loss distributions andthe loss percentiles at various confidencelevels.

Capital is the loss percentile in excess ofexpected loss totaling 9.5, or 100 9.5 =

90.5.At a 1% confidence level, leading to a losspercentile of 100 for the portfolio A + B and acapital of 100 9.5 = 90.5.

At a 0.5% confidence level would result in a

maximum portfolio loss of 150 and a capitalof 150 9.5 = 140.5.

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The Marginal Risk Contributions toCapital

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The marginal risk contributions to theportfolio loss volatility are lower than the

absolute risk contributions.

Marginal risk contributions to portfolio capitalcan be higher or lower than absolute risk

contributions to capital.

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General Properties of Marginal RiskContributions

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Relation between the Marginal andAbsolute Risk Contributions

MRCf= P+f P

P+f= ARCP+fP + ARCP+f

Marginal versus Absolute RiskContribution for a New Facility

MRCf < ARCP+ff < f

The difference between MRCfand ARCP+f

f is (ARCP+f

P

P )

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MARGINAL RISKCONTRIBUTIONS TO VOLATILITY VsABSOLUTE RISK CONTRIBUTIONS TO VOLATILITY

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Ex Ante versus Ex Post Views of Risk and

Return

Capital Allocation

Risk-adjusted Performance versus Risk-based

Pricing

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CAPITAL ALLOCATION VIEW Vs PRICINGVIEW

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Ex Ante Ex Post

MarginalRisk Contributions

AbsoluteRisk Contributions

Risk-based Pricing

Pricing Consistent withTarget Return

Capital Allocation

Risk-adjustedPerformance

Ex Ante versus Ex Post Views of Riskand Return

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THANKS TO ALL

Documents

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