What to include in your FTPs?

Bank internal reference prices (#FTP) are a subject of high interest in the professional community. Bankers can, with the help of a well-configured FTP system, carry out a truly professional financial management of the bank. That is why I always pay special attention to FTP in our projects and workshops in the area of asset-liability management (#ALM).

I also explain the functioning of FTP in a bank in my popular article on LinkedIn here: https://www.dhirubhai.net/pulse/funds-transfer-pricing-ftp-bank-martin-macko

However, I have received additional questions about the construction of internal reference prices (FTP) - how to correctly allocate the liquidity premium to FTP, and whether the bank's equity costs should also be part of FTP.

Liquidity costs as part of FTP

Each bank has to build its own liquidity curve, i.e. create a liquidity premium for each maturity. Liquidity premia are specific to each bank, unlike the basic FTP, which is based on the risk-free interest rate in the financial market. Thus, while the base FTP reflects macroeconomic developments in a given market, the liquidity premium of a bank reflects the credit risk of that particular institution.

The creation of liquidity premium is a challenge for many banks. In principle, the own liquidity curve can be constructed according to the following factors:

• Own (uncovered) bond issues
• Bond issues of another (similar) bank with the same ratings in the financial market
• Most expensive own deposits at different maturities
• Approximations

Obviously, many medium-sized and smaller banks are not issuers of their own uncovered bonds, nor can they find a similar bank in their regional market that would be such an issuer. They then have to rely on estimates from their own deposits and various models to construct the liquidity curve. Nevertheless, it is extremely important that each bank has its own liquidity curve. A liquidity premium should be part of any FTP.

In constructing the liquidity curve, the following rules shall apply:

• LQ premium is higher if the maturity is longer
• LQ premium is higher if the bank's reputation (creditworthiness, rating) declines

A bank should allocate liquidity premium to each balance sheet item exclusively according to their maturity. The interest rate profile for variable rate products is not relevant, ONLY the maturity is the determining factor. For administered balance sheet items without maturity (e.g. overdrafts or retail sight deposits), the modelled maturity is used.

Liquidity premiums have this effect on banking products:

• the liquidity premium is always added to the basic FTP;
• for liabilities, this means that by including the liquidity premium, the bank creates a higher margin or can offer a more attractive rate to clients;
• for assets, it means that the bank's clients will receive a less attractive rate or the bank will work with a smaller margin;
• Banks with worse reputations (and thus higher liquidity premium) therefore usually offer more attractive deposit rates, but at the same time less attractive lending rates.

Cost of equity and FTP system

First, it is necessary to define what is meant by equity cost (EC) in the context of the financial management of a bank.

Let's try to explain it with a simplified example: let's imagine that the shareholders of a bank demand ROE (Return on Equity) at 7%. The capital, i.e. the assets of the shareholders, should therefore earn such a return. At the same time, the bank needs this capital to cover unexpected risks. A certain part of the capital must be allocated to the relevant risks in the sense of the regulation. For example, if a bank grants a loan to a client, it must allocate a certain amount of capital according to the client's credit rating under the rules (ICAAP - Internal Capital Adequacy Assessment Process, part of Pillar 2 within the Basel Framework). This fact then implies that if the bank wants to "earn" the required ROE from this loan, it should also add such capital costs to the margin of the loan. In this sense, we could add an equity cost to the FTP on the loans.

The FTP system serves us, among other things, to be able to define the returns from a given risk.

We could also determine how much the EC should be in this case in relation to the FTP. For this we need to know:

• what is the regulatory capital adequacy of the bank. So, in terms of the Basel rules, after taking into account all the buffers, let this bank have regulatory capital requirement of at least 15.5% of risk-weighted assets.
• For this case, let our loan be a loan of medium risk category (e.g. BB rating), which has a risk weight of 100% of the principal. Then we need to allocate capital of 15.5 to a principal of 100.
• This capital can only be invested in some very low-risk asset (e.g. high-credit government bonds) at the risk-free current interest rate on the capital market. In our case, let this rate be 3%p.a.

Then we determine our cost of capital as follows:

(Expected ROE 7% - Current yield on the capital market 3%) x Regulatory capital requirement 15.5% = 0.62%

So what now? Could we add an equity cost premium to the FTP of risk-weighted assets?

In theory, yes, BUT....

It is necessary to consider that the FTP system in a bank is supposed to be a transparent risk-based pricing system. With the help of FTP, the bank's financial management is supposed to determine the bank's return on a given risk. For example, by assigning a liquidity premium (as a part of FTP) to all items on the balance sheet, we can find out what our liquidity costs and revenues are for each of the bank's products. Adding various overlapping incentives and add-ons that do not directly reflect risk returns can undermine the FTP objective.

As can be seen from the above example, the level of equity costs (EC) is directly related to the shareholders' willingness to achieve a certain ROE. Shareholders can decide what ROE they want. In addition, such an add-on to FTP could only be applied to certain products that require capital allocation (e.g. loans), but it is not possible to apply it to products without a capital requirement (e.g. deposits).

Therefore, it can be concluded that the adding of banks' cost of equity capital to FTP may not be appropriate. Nevertheless, it is up to each bank individually to add such an element to its FTP system.

If you want to learn more about asset and liability management (ALM) and the use of FTP, don't hesitate to take advantage of Bearning 's consulting, interactive live workshops and e-learning:

• https://bearning.com/
• https://study.bearning.com/
• https://study.bearning.com/pages/consulting

? 2023 Bearning, s.r.o.

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