Mohi Risk Management

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Risk Management in Banking (B-505)

Presented By

Shah Mohammad Mohiuddin

ID#12-038


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Chapter -26FTP Systems


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Introduction

Two main tools for integrating global riskmanagement with Decision-making.

Funds Transfer Pricing (FTP) system

Capital allocation system.

FTP serves to allocate interest incomeCapital allocation system serves to

allocate risks


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FTP Systems addresses Three major issues

for commercial banking

The goals of the transfer pricingsystem

The transfer of funds acrossbusiness units and with the ALMunits

The measurement of performancegiven the transfer price


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FTP system specifications

Transferring funds between units.

Setting target profitability for business units.

Transferring interest rate risk, which is beyond the

control of business units, to ALM.ALM missions are tomaintain interest rate risk within limits.

Pricing funds to business units with economicbenchmarks, using economic transfer prices.

Eventually combining economic prices with commercialincentives.


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GOALS OF THE TRANSFER PRICING SYSTEM

Allocate funds within the banks

Calculate the performance margins ofa transaction

Define economic benchmarks forpricing and performancemeasurement

Define pricing policiesTransfer liquidity and interest rate risk

to the ALM unit


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Funds Transfer Pricing system and its

applications


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INTERNAL MANAGEMENT OF FUNDS AND

NETTING

Internal Pools of Funds

Netting:


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Pricing all Outstanding Balances


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MEASURING PERFORMANCE


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The FTP System and margin calculations

The Accounting Margin: Example

Given,Transfer Price = 9.20%

Direct calculation of the accounting margin

2000 12% 1200 6% 800 9%= 96


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ALM Profitability and Risks

Cost center: If its target profit is set to zero.

responsibility is to minimize the cost of funding hedge the bank against interest rate risk. This cost saving is its Profit and Loss (P&L).

Profit center: Has a target profit. Optimize the funding policy within specified limits

on gaps, earnings volatility or Value at Risk (VaR).

Liquidity and interest rate risks should actually beunder ALM control.

commercial margins should not have any exposureto interest rate risk


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RATIONALE OF TRANSFER PRICES

Financial standpoint: Transfer prices should reflect market conditions

Commercial standpoint:

Customer prices should follow business policy

guidelines subject to constraints from competition.

Mispricing:

Mispricing is the difference between economicprices andeffective pricing. Mispricing is not an error since it isbusiness-driven. Nevertheless, it deserves monitoring forprofitability and business management. Monitoringmispricing implies keeping track of target prices andeffective prices, to report any discrepancy between the two.


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Chapter -27

Economic Transfer Prices


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Economic Transfer Pricing

Arbitrage opportunitiesbetween bank rates &market rates wheneverdiscrepancies appear

Economic Benchmarkderive from market price

Economic Benchmark fortransfer prices all-in costof funds, which is applied

to lending activates


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Commercial Margin & Maturity spread

Spread means difference between lending long &

borrowing short

Commercial margin contributes to the accountingmargin & under the control of ALM

Bank can borrow the money on the market &

have a positive margin whatever the maturity


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Pricing Schemes

Lending Activities

Risk based pricing is the benchmark & should bepurely economic. It implies two basic elements

Cost of funds

Mark-up


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Pricing Schemes (contd.)

Commercial pricing refers to mark-

ups & mark-down over economic

benchmark to drive the businesspolicies

To get the economic transfer priceother economic cost should be

added-up


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Transaction vs. Client Revenues & Pricing

Bank provides products & services &

obtain interest spread & fees ascompensation

Client revenue is the relevant measure forcalculating profitability


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The cost of funds for loans

Volumes of assets & resources of a given

category(Long term, short term) should be

matched For the business unit, any deficit needs matching

resources of other business unit. The collection

of cheap resources should rather increase the

profitability of the unit getting

Any cheap resource, such as deposits, subsidizes

the profitability of assets. Matching a long-termloan with the core fraction of demand deposits

might be acceptable in terms of maturity

The cost ofexisting

resources


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The Notional Funding ofAssets:

It does not depend on the existing

resources

It serves as a benchmark fordetermining the cost of funds backing

any given asset

Outstanding balance varies over time

until maturity where the market rateof this maturity is not adequate & it

would assume that the loan does not

amortize over time

DebtSpot 1year

Debt Spot 2year

40

60

2 Year1 Year

Outstandingbalance


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The Benefits of Notional Funding

The margin of the asset is immune to interest ratemovements

There is no need for conventions to assign existingresources to usages of funds

There is no transfer of income generated by

collecting resources to the income of lendingactivities

The calculation of a transfer price is mechanical &easy


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Benchmarks For Excess Resources

Under a global view, the bank

considers global management of both

loan and investment portfolios

The management of invested fundsintegrates with ALM policy


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Chapter 51

Capital Allocation & Risk Contributions


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Risk Contributions are two kinds:

Absolute risk contributions (ARC)

Marginal risk contributions (MRC)

ARCCapital allocation

MRCPricing purpose


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Capital Allocation Goals

The goals of capital allocation :Aims at allocating both credit and market risk to the business units

and the transactions that originate them

To provide the top-down and bottom-up links between the post-

diversification risk of the bank and individual transactionsRisk contributions of facilities to the overall portfolio risk.

Allows to break down and aggregate risk contributions according

to any criteria as long as individual transaction risk contributions

are available


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DEFINITIONS AND NOTATION

DEFINITIONSThe standalone risk is the loss volatility of a single facility

Marginal risk contribution is the change in portfolio loss

volatility when adding a facilityfto portfolio p

Absolute risk contribution of an existing facility i to

portfoliop is the covariance of the random loss of this single

facility i with the random loss aggregated over the entire

portfolio (including i), divided by the loss volatility of this

aggregated loss.


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DEFINITIONS AND NOTATION (Contd.)

NOTATION:

For the single facility i, the loss is Li .

The exposures are Xi , i = 1 to N. Li , i = 1 to N. Exposures

are certain and identical to losses given default.

To make random losses distinct from certain exposures, we

use Li

for losses andXifor exposures

a random variable describing the credit state of the facility

di


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Properties of Risk Contributions

The absolute risk contributions serve to allocate

capital. Marginal risk contributions serve to make

incremental decisions

Absolute risk contributions: To make ex post

allocations of capital based on effective usage of line

Marginal risk contributions: To make ex ante risk-

based pricing decisions.


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Definition of ARCs to Volatility:

This formula defines the absolute risk contribution to portfolio volatility,ARCP:

Simplified Formulas for Risk Contributions:The two main formulas of absolute risk contributions to portfolio volatility are

either in terms of the correlation of in visual losses with aggregated lossesor in terms of the i coefficient, which is the coefficient of the relation

between individual losses and the portfolio loss: i


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The Capital Allocation Model & ARCs Risk Contributions Capture Correlation Effects:

Risk contributions combine the correlation effect with the portfolioand the magnitude of the standalone risk.

These risk contributions sum to the loss volatility, not the capital:

From Absolute Risk Contributions to Capital Allocation:

In order to proceed to capital allocation, we need the multiple ofloss volatility providing the capital at a given confidence level.

To obtain the capital allocations, we need to multiply the riskcontributions by a multiple m(),


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The Capital Allocation Model & ARCs (Contd.)

From Absolute Risk Contributions to Capital

Allocation:

In order to proceed to capital allocation, weneed the multiple of loss volatility providing the

capital at a given confidence level. To obtain the capital allocations, we need to

multiply the risk contributions by a multiplem(),

Absolute risk contributions to portfolio lossvolatility and capital allocation:


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Chapter 52

Marginal Risk Contributions


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General Properties of Marginal Risk Contributions

MRC to the portfolio risk volatility < ARC.MRC

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