Financial Stability Institute
Financial Stability InstituteOccasional PaperNo 10Liquidity transfer pricing:a guide to better practiceJoel GrantAustralian Prudential RegulationAuthorityDecember 2011
The views expressed in this paper are those of their authorand not necessarily the views of the Financial StabilityInstitute, the Bank for International Settlements or theAustralian Prudential Regulation Authority.This publication is available on the BIS website (www.bis.org). Financial Stability Institute 2011. Bank for InternationalSettlements. All rights reserved. Brief excerpts may bereproduced or translated provided the source is cited.ISSN 1020-8461 (print)ISSN 1020-9999 (online)
ContentsList of abbreviations . vExecutive summary . 11.Introduction . 31.1 A summary of the major lessons learned . 61.1.1 Governance of the LTP process. 61.1.2 The application of LTP. 71.1.3 Sizing and attributing the costs ofliquidity cushions . 81.2 Regulatory developments . 81.3 The need for more guidance on LTP . 92.Governing LTP . 112.1 Management of the LTP process. 122.1.1 LTP policies . 122.1.2 Internal funding structure – centralisedvs decentralised. 132.1.3 Trading book funding policies andidentifying funding requirements . 132.1.4 Oversight . 152.1.5 Towards better LTP practice . 152.2 Liquidity Management Information Systems(LMIS) . 172.3 Remuneration practices. 183.LTP in practice: managing on-balance sheetfunding liquidity risk. 203.1 Why banks need LTP. 203.2 An example of what can go wrong withpoor LTP . 213.3 “Zero” cost of funds approach – liquidity asa “free” good . 213.3.1 Why did some banks choose thisapproach?. 23FSI Occasional Paper No 10iii
3.4Pooled “average” cost of funds approachto LTP.243.4.1 Problems with the pooled “average”cost of funds approach .253.4.2 Implications of pooled “average”cost of funds approach .283.5 Matched-maturity marginal cost of fundsapproach to LTP.303.5.1 How are rates for users and providersof funds determined? .313.6 Examples of pricing funding liquidity risk .323.6.1 Non-amortising bullet loans .333.6.2 Amortising loans .343.6.3 Deposits .383.7 Summary .404.LTP in practice: managing contingent liquidity risk .404.1 Liquidity cushions: a principle of liquidityrisk management.424.2 Extant guidance focuses on size, compositionand marketability .424.3 Problems with banks liquidity cushionsunveiled by the GFC .434.4 LTP and liquidity cushions – both principles,both treated separately .444.5 Poor attribution of cost of carrying a liquiditycushion .444.6 Towards better management of contingentliquidity risk.474.7 Example of pricing contingent liquidity risk .505.Conclusion .51Appendix: LTP principles and recommendations .56ivFSI Occasional Paper No 10
List of abbreviationsBCBSBasel Committee on Banking SupervisionCEBSCommittee of European Banking SupervisorsCRMPG IIICounterparty Risk Management Policy Group IIIECEuropean CommissionFSBFinancial Stability BoardFTPFunds Transfer PricingIIFThe Institute for International FinanceGFCglobal financial crisisLCRLiquidity Coverage RatioLIBORLondon Interbank Offer RateLMISLiquidity Management Information SystemsLTPLiquidity Transfer PricingNSFRNet Stable Funding RatioSSGSenior Supervisors GroupWGLWorking Group on LiquidityFSI Occasional Paper No 10v
Executive summary1This paper identifies better practices for liquidity transferpricing (LTP) by drawing on the responses to an internationalsurvey that covered 38 large banks from nine countries. Thesurvey focused on the enhancements banks are making totheir LTP processes.Responses to the survey show that many LTP practices werelargely deficient. Many banks lacked LTP policies, employedinconsistent LTP regimes, relied on off-line processes tomanually update changes in funding costs, and had pooroversight of the LTP process. Probably the most strikingexample of poor practice was that some banks failed toattribute liquidity costs to assets and conversely liquiditycredits to liabilities for some business activities. Others didattribute liquidity costs and benefits, albeit at one average rate.This approach failed to penalise longer-term fundingcommitments for assets and, conversely, reward longer-termfunding benefits from liabilities, and failed to incorporate timelychanges in banks’ actual market cost of funds. Moreover,banks’ liquidity cushions were too small to withstandprolonged market disruptions and were comprised of assetsthat were thought to be more liquid than they actually were.Overall, these shortcomings encouraged risky maturitytransformation, without regard to the structural liquidity riskthat was being generated.1The author is grateful for comments received from APRA colleagues, inparticular, John Laker, Charles Littrell, Katrina Ellis, Bruce Arnold, NeilGrummitt, Nick Palmer and members of APRA’s Research Unit. I wouldalso like to thank Jim Embersit from the Board of Governors of the FederalReserve System, Kumar Tangri from the UK Financial Services Authority,and members of the Basel Committee on Banking Supervision’s WorkingGroup on Liquidity.The author can be contacted at: joel.grant@apra.gov.au.FSI Occasional Paper No 101
Better LTP practice requires each bank to produce and followan LTP policy that defines the purpose of LTP and providesprinciples and/or rules to ensure LTP achieves its intendedpurpose. Banks should manage LTP centrally, such as ingroup treasury, with sufficient oversight provided byindependent risk and financial control personnel. Treasuryshould have complete visibility of individual business balancesheets. To properly manage funding liquidity risk, banksshould charge rates based on their marginal cost of funds andmatched to the maturity of the product or business activity atorigination. For amortising or non-maturing products, blendedmarginal rates should be applied. In regard to the sizing ofliquidity cushions, banks should use the results of stresstesting and scenario analyses, which include idiosyncratic andmarket-wide disruptions, as well as a combination of the two.Assets held as part of banks’ liquidity cushions should be ofthe highest quality to ensure liquidity can be generated whenneeded. Finally, business activities creating the need forbanks to carry additional liquidity should be charged based ontheir expected usage of contingent liquidity.Overall, better LTP practices will ensure that banks accrueless illiquid and correlated assets, use more stable sources offunding to meet the demands of their business activities, andcarry a more sufficiently sized liquidity cushion to withstandunexpected idiosyncratic and/or market-wide disruptions.Banks, supervisors and other stakeholders are thereforeencouraged to consider the better LTP practices that areidentified in this paper.2FSI Occasional Paper No 10
1.IntroductionInternal transfer pricing is an extremely importantmanagement tool for banks. This paper observes that until theglobal financial crisis (GFC), many banks treated liquidity as afree good for transfer pricing purposes, and this was onecause for the very poor liquidity outcomes experienced duringthe GFC. Furthermore, although liquidity transfer pricing (LTP)practices are improving, there is little guidance publiclyavailable to banks, regulators, and other stakeholders on whatconstitutes good practice. This paper makes a start on fillingthat gap.LTP is a process that attributes the costs, benefits and risks ofliquidity to respective business units within a bank.2 LTP hasgained considerable attention since the onset of the GFC withsome reports linking poor LTP practices to the funding andliquidity issues witnessed at several banks (SeniorSupervisors Group (SSG), 2008; 2009).The purpose of LTP is to transfer liquidity costs and benefitsfrom business units to a centrally managed pool. To achievethis, LTP charges users of funds (assets/loans) for the cost ofliquidity, and credits providers of funds (liabilities/deposits) forthe benefit of liquidity. LTP also recoups the cost of carrying aliquidity cushion by charging contingent commitments, such aslines of credit, based on their predicted (expected) use ofliquidity. This is depicted in Figure 1 below. Banks with poorLTP practices typically under-price or (even worse) fail to priceliquidity. Such banks are more likely to accrue illiquid assetsand contingent exposures, and under-value stable sources offunding. This outcome applied to many banks and otherfinancial institutions prior to the GFC.2In this regard, LTP forms part of the funds transfer pricing (FTP) process.FSI Occasional Paper No 103
4FSI Occasional Paper No 10Business unit 1:provides fundsBusiness unit 1 receives credits fromtreasury based on the commitment offunds provided. Credits are reduced byany charges against contingentcommitments, such as deposit run-off.Trading businessLiquiditycushionInternal treasury(central pool)Interbank market:provides fundsThe trading business uses funds, providesfunds (through the sale of marketablesecurities) and receives charges againstcontingent commitments, such as collateralcalls on derivative positions.Business unit 2:uses fundsBusiness unit 2 incurs charges fromtreasury based on the commitment offunds required. Additional charges willapply to contingent commitments, suchas lines of credit.A graphical representation of the LTP processFigure 1
In the years preceding the GFC, liquidity was plentiful andcheap, and as we now know, unsustainably plentiful andcheap. Some of the larger and more creditworthy banks couldobtain long-term funding at only the slightest margins aboveswap rates. Such ideal funding conditions proved fruitful forbanks, widely encouraging leverage and maturitytransformation, which underpinned their record profits. At thesame time these conditions led many to believe that fundingwould always be available, and at permanently cheap rates.One consequence of this belief was that it provided littleincentive for banks to devote attention to liquidity riskmanagement. As a result, many banks failed to recognise thetrue nature of the liquidity risk embedded in their business3activities.One principle of liquidity risk management that lackedattention was LTP. In 2009, a group of prudential regulatorsconducted an international survey to assess the progressbanks are making to enhance LTP. The survey covered38 banks from nine countries. Total assets of the bankssurveyed ranged from less than US 250 billion to greater thanUS 1 trillion.The survey responses revealed that many of the LTPpractices employed by banks were short of good practice. Thispaper extracts the lessons learned from the survey, andmakes a first attempt at establishing better LTP practice. Forconfidentiality reasons, however, it is not possible to quote orreference directly from any of the survey responses.3This claim is supported by the Basel Committee on Banking Supervision(BCBS), which reported that many of the basic yet fundamental principlesof liquidity risk management were neglected by banks. For moreinformation, see Liquidity Risk: Management and Supervisory Challenges,BCBS, (February 2008).FSI Occasional Paper No 105
1.1A summary of the major lessons learned1.1.1 Governance of the LTP processMost banks included in the survey lacked an LTP policy. Assuch, LTP was not defined nor were there any rules orprinciples in regard to how LTP should operate. Typically, thisoutcome meant that liquidity generators (such as retailbranches raising deposits) were underpaid for their liquiditycreation, and liquidity users (such as lending, investment, andtrading portfolios) received free or unduly cheap liquidity.Where banks in the survey were operating with decentralisedfunding centres, most had inconsistent LTP regimes. Inaddition, these banks relied on manual off-line processes tointervene and to update relevant funding costs, and were moreprone to arbitrage between business units and internaltreasuries.For many of the banks in the survey with large tradingbusinesses, internal treasuries often lacked visibility nderstanding of individual funding requirements andcontingent liquidity exposures. Most of the time this resulted intreasuries charging all trading businesses based on their netfunding requirement, with no add-ons for the implicit risk of ablow-out in liquidity needs.Oversight of the LTP process at nearly all banks thatparticipated in the survey was poor to nonexistent, especiallyby risk and financial control functions. This was one of thefactors that resulted in the accumulation of highly illiquid (andoften correlated) assets and the excessive reliance uponshort-term (often overnight) funding.Liquidity Management Information Systems (LMIS) employedby most of the banks surveyed were simplistic and inflexible.Many of the systems were unable to attribute the costs,benefits, and risks of liquidity appropriately to respectivebusinesses, and at a sufficiently granular level. This resulted in6FSI Occasional Paper No 10
product mispricing, which distorted profit and performanceassessments.For a large proportion of banks included in the survey, theirLTP process failed to account for the costs, benefits and risksof liquidity in the pricing and performance assessment ofvarious products and business units. As a result, profitmeasures used as a basis for determining business unitperformance and executive remuneration were distorted. Profitpools, for example, which are generally used to determineshort-term incentives (bonuses) for employees, were derivedfrom a simple percentage of accrued revenues without anyregard for the liquidity risk taken to generate such profits.4 Thisencouraged revenue and risk maximisation rather than riskadjusted earnings.1.1.2 The application of LTPProbably the most striking example of poor LTP practice washow some of the banks that were surveyed treated liquidity asa “free” good, completely ignoring the costs, benefits and risksof liquidity. These banks neglected to charge or creditrespective businesses, products and/or transactionsaccordingly. This was particularly the case for much of thecontingent or unfunded business that was written. Examplesincluded trading and investment banking activities, lines ofcredit, the need to prepare for collateral calls, and variablerate (adjustable-rate) products including home mortgages.Most of thethe costs,businesses.employed a4banks surveyed recognised the need to attributebenefits and risks of liquidity to respectiveHowever, a large majority of these bankspooled average cost of funds approach to deriveBonus pools often neglected other risks, not just liquidity, and the cost ofcapital employed to generate such profits. This is the subject of anotherpaper.FSI Occasional Paper No 107
the costs and benefits of liquidity. This resulted in short- andlong-term assets receiving the same charge for the cost ofliquidity and, conversely, short- and long-term liabilitiesreceiving the same credit for the benefit of liquidity.1.1.3 Sizing and attributing the costs of liquidity cushionsFor a large majority of the banks surveyed, liquidity cushionswere derived from stress assumptions stemming mainly fromidiosyncratic funding scenarios, revolving around a singlebank’s sudden inability to raise funds. Having little or noregard to systemic funding scenarios, most cushions were toosmall to withstand prolonged or deep market disruptions.In addition, cushions comprised liquid assets that werethemselves funded short-term. This meant that the cost ofcarrying the liquidity cushion was quite small, but the realvalue of the cushion in addressing sudden (contingent)liquidity risks was also minimal. This costing and fundingarrangement provided insufficient incentive for banks toattribute true costs back to business units on an expected orpredicted usage basis but, rather, to opt for the simpler butincorrect method of averaging the cost across all assets.1.2Regulatory developmentsThe Basel Committee on Banking Supervision (BCBS) hasbeen central to regulatory developments in liquidity, firstpublishing Sound Practices for Managing Liquidity in BankingOrganisations in February 2000. Following this, in 2006, theBCBS established the Working Group on Liquidity (WGL) to“serve as a forum for information exchange on nationalapproaches to liquidity supervision and regulation”. Thegroup’s initial mandate was to review and evaluate liquiditysupervision practices, and banks’ approaches to liquidity riskmanagement, with respect to the sound practices alreadyestablished.8FSI Occasional Paper No 10
This work was the first to highlight the basic yet fundamentalelements that were missing from bank liquidity management.These findings formed the basis of the report Liquidity Risk:Management and Supervisory Challenges (February 2008)and sparked a review of the February 2000 sound practices.An updated version of these practices, articulating17 principles, was released as Principles on Sound LiquidityRisk Management and Supervision (September 2008). Since2008 the BCBS has released Principles for Sound StressTesting Practices and Supervision (May 2009) and morerecently, Basel III: International Framework for Liquidity RiskMeasurement, Standards and Monitoring, aimed at improving5the resilience of the financial system (December 2010). Aspart of this, two global standards for liquidity risk weredeveloped. First, a Liquidity Coverage Ratio (LCR) to ensurebanks have sufficient high quality liquid assets to survive anidiosyncratic shock and, second, a Net Stable Funding Ratio(NSFR) to encourage banks to fund their business activitiesusing more stable sources of funding.1.3The need for more guidance on LTPThe scale and extent of liquidity reform is large. But, given theweaknesses in bank liquidity risk management approachesunveiled by the recent crisis, it is not surprising that certainprinciples require further guidance. This is particularly the casefor LTP.Extant guidance is broad but merely encourages banks toinclude liquidity risk in their internal pricing mechanisms,without providing specific help.6 For example, Principle 4 of the5These papers can be accessed via http://www.bis.org/list/bcbs/sac 1/index.htm.6A complete list of principles and/or recommendations provided by variousregulatory and non-regul
cost of funds approach .25 3.4.2 Implications of pooled “average” . iv FSI Occasional Paper No 10. FSI Occasional Paper No 10 v List of abbreviations BCBS . . management tool for banks. This paper observes that until the global financial crisis (GFC), many banks treated liquidity as a
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