The failures of firms like Countrywide, Washington Mutual, IndyMac, Lehman Brothers, Citigroup and FNMA have convinced many that it is dangerous to take a silo approach to interest rate risk management ("ALM" or asset and liability management) and to rely on legacy risk vendors that address that aspect of risk alone. This post explores how the concept of funds transfer pricing, originated by Wm. Mack Terry's team in the Financial Analysis and Planning group at Bank of America in 1973, is evolving to give a more accurate and more holistic view of total risk, not just interest rate risk alone.
Chapter 2 of Advanced Financial Risk Management (van Deventer, Imai and Mesler, 2004, John Wiley & Sons) outlines the rationale behind Mack Terry's funds transfer pricing system at the Bank of America. Management was funding 30 year fixed rate mortgages with short term funding, and Mack wanted to make sure that the full risk exposure and the responsibility for it were in full public view. In light of the current crisis, many bankers are building on this foundation to improve still further on the measurement of risk and identification of the sources of risk in large financial services organizations. Funds transfer pricing is one of the most important tools for achieving this objective. These are the emerging "best practice" enhancements to funds transfer pricing that we see Kamakura Risk Manager users employing to protect shareholder value and the interests of clients and shareholders.
1. Measuring "Net Interest Margin" versus Both the Risk-free Yield Curve and the Firm's Marginal Cost of Funds Yield Curve
The original intent of funds transfer pricing was to isolate the interest rate risk of the firm into a "funding center" that could then look at interest rate mismatches one by one. This is still one of the objectives of best practice funds transfer pricing, but now the ambitions for the discipline are much larger and more important. Best practice bankers and insurance experts are now "transfer pricing" with respect to two yield curves on a matched maturity basis: the traditional way, using the bank's or insurance firm's marginal cost of funds yield curve, and a more modern way which measures the full credit spread on every asset and liability. The traditional spread versus the marginal cost of funds curve shows the financial accounting profits that would accrue if the asset were "match funded." On the liability side, it shows the savings from originating liabilities that cost less than funds in the wholesale markets. On the other hand, from a risk management perspective, the traditional transfer pricing spread mixes the credit risk of the asset being funded with the credit risk of the bank or insurance company. By explicitly measuring the true credit spread of the asset versus the risk free rate, the full compensation to the financial services firm for taking on the credit risk of the asset is in full view. This is a big step forward.
2. Measuring the Linkages between Macro Economic Factors and True Credit Spreads
Once the true credit spreads on each asset have been measured, the financial services firm can then do what the Federal Deposit Insurance Corporation and the Federal Reserve have ordered the 19 largest banks in the United States to do: stress test the value of all assets with respect to changes in key macro factors. The March 2009 instructions from U.S. regulators focus on home prices, the civilian unemployment rate, and gross domestic product, but many other macro factors are important as well. Understanding these linkages and stress testing credit spreads and asset values with respect to macro factors provides management with the true macro factor exposures. Merrill Lynch, UBS and Citigroup all admitted at a very senior level that it was a lack of visibility on these exposures that resulted in all three firms' overexposure to the U.S. housing market
3. Measuring the Credit Sensitivity of the Supply of Liabilities to the Firm
For many years, financial services firms have tried to better understand how assets and liabilities generated affect the risk that the bank or insurance firm cannot fund itself in a crisis. This is not an academic exercise, as firms like GE, American Express, General Motors and Ford have had to seek U.S. government support in the current crisis, in addition to well publicized bail-outs of AIG and Citigroup. Perhaps the biggest revelation in this regard is that "core deposits" are not "core." Many bankers had, via their transfer pricing system, given extra liquidity "credit" to retail demand deposits, savings deposits, and even small lot certificates of deposit on the theory that retail depositors were less likely to flee in a crisis. The September 15, 2007 run on Northern Rock in the U.K, and similar runs on IndyMac in California and Bank of East Asia in Hong Kong have shown that this assumption may have been overly optimistic. Financial services industry risk managers now realize that macro factor movements impair asset values and that liability suppliers, even those at the retail level, do their own "credit risk CAT scan" of the balance sheet and flee when assets are significantly impaired. In the case of Northern Rock, for example, the bank had never reported a loss prior to the run on the bank. For both IndyMac and Northern Rock, retail depositors fled even knowing full well that government deposit insurance was in place. This was a rational response designed to avoid the hassle and inconvenience of a rescue by simply taking one's business to the sounder bank across the street. Now that this phenomenon has been played out on television for all the world to see, bankers and insurance firms have become much more precise in measuring the true credit-adjusted effective maturity of retail deposits and insurance policy cash values. For more on what happened at Northern Rock and Countrywide, see the Kamakura brochure "Kamakura Risk Manager In Depth."
Donald R. van Deventer
Honolulu, April 3, 2009