Banking: Modeling Methodology

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SEPTEMBER 2011

MODELING METHODOLOGY
Authors
Robert J. Wyle, CFA Yaakov Tsaig, Ph.D

Implementing High Value Funds Transfer Pricing Systems
Abstract
Funds transfer pricing (FTP) is the process through which banks allocate earnings to the various lines of business in which they are engaged. The realization that FTP is an important part of enterprise risk mitigation has sparked new interest in this technique, both in regulatory publications and industry findings. Like any other complex control system, a large body of FTP practices has evolved over time. In this paper, we explore traditional FTP approaches and highlight best practices in FTP methodologies and implementation. We advocate an economic approach when calculating transfer prices, which accounts for the financial risks inherent in an exposure. We emphasize the importance of designing an FTP framework that addresses funding liquidity risk, in light of recent economic events, with increased focus on liquidity management. We demonstrate how an economic approach can be used as a means of disaggregating a transfer price into different components and associating appropriate premia to each component. This decomposition facilitates risk transfer between the funding unit and the various business lines in a manner that aligns the financial incentives of the different units. We point to the linkages between FTP and risk-adjusted performance measurement, and suggest that an economic FTP framework can be viewed as a bridge between risk-based pricing and commercial pricing.

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Table of Contents
1  2  Introduction ........................................................................................................................................................... 5  Funds Transfer Pricing – Common Industry Practices .......................................................................................... 5  2.1FTP Applications .............................................................................................................................................................................................................5 



Funds Transfer Pricing: Goals and Objectives .......................................................................................................6  3.1Measure Business Unit Profitability Independent of Interest Rate Risk ................................................................................................................. 6  3.2Centralize the Measurement and Management of Interest Rate Risk (IRR): ......................................................................................................... 6  3.3Provide Consistent Product Pricing Guidance to Business Lines ............................................................................................................................. 7  3.4Set Profitability Targets for Business Units ................................................................................................................................................................ 7 

4  Funds Transfer Pricing Basics.................................................................................................................................8  4.1Funds Transfer Pricing Approaches ............................................................................................................................................................................. 8  4.2Break Funding Charges ..................................................................................................................................................................................................9  4.3A Simple Funds Transfer Pricing Example...
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