Federal Banking Agencies Issue Guidance on Funds Transfer Pricing for Funding and Contingent Liquidity Risks
The Federal Reserve, the FDIC, and the OCC (the “Agencies”) recently issued guidance on supervisory expectations for funds transfer pricing (“FTP”) practices related to the allocation of funding and contingent liquidity risks to a firm’s business lines, products, and activities.1 The guidance applies to U.S. bank holding companies with total consolidated assets of $250 billion or more or foreign exposures of $10 billion or more, depository institutions with total consolidated assets of $250 billion or more, and foreign banking organizations with combined U.S. assets of $250 billion or more and is intended to address perceived weaknesses observed by the Agencies in some firms’ FTP practices and builds upon the Agencies’ 2010 “Interagency Policy Statement on Funding and Liquidity Risk Management.”2
According to the Agencies, the 2008 financial crisis exposed weak risk management practices for allocating funding and contingent liquidity costs and benefits across business lines, resulting in “significant levels of illiquid assets” and “significant risks that were held off-balance sheet,” each leading to “sizable losses.”3 The guidance document describes FTP as an important tool for centralizing the management of these risks to take “a broader view of the firm,” which can promote “more resilient and sustainable business models.”4
The Agencies’ guidance states that covered firms should have an FTP framework that incorporates the four general principles outlined below and that is “commensurate with its size, complexity, business activities, and overall risk profile.”5 The FTP framework should be designed to: (i) manage the costs and benefits associated with funding and contingent liquidity risks of each of the firm’s business lines, products, and activities; (ii) incorporate FTP costs and benefits into product pricing and new product approval for all material business lines; and (iii) ensure that such risks are properly measured and align with the firm’s overall risk profile.6 The Agencies note that the guidance is not intended to replace broader liquidity risk management practices and programs (for example, the liquidity coverage ratio and liquidity stress testing, including pursuant to enhanced prudential supervision requirements implemented under Section 165 of the Dodd-Frank Act), but rather is designed to ensure that covered firms have a framework for incorporating funding and contingent liquidity risk considerations into their day-to-day operations. The Agencies note that the framework should be tailored to a covered firm’s “size, complexity, business activities, and overall risk profile.”
PRINCIPLES OF SOUND FTP RISK MANAGEMENT
The four principles set forth in the guidance include:
- Principle One: A firm should allocate FTP costs and benefits based on funding risk and contingent liquidity risk.
- Funding risk: A covered firm’s funding risk should be measured as the cost or benefit of raising funds to finance business operations, including business lines, products, and activities.
- Contingent liquidity risk: A covered firm’s contingent liquidity risk should be measured as the cost of holding standby liquidity (that is, unencumbered highly liquid assets or lines of credit) that may be needed to cover contingent funding, such as collateral calls, deposit runoff, and increased asset haircuts during a stress event.
- Principle Two: A firm should have a consistent and transparent FTP framework for identifying and allocating FTP costs and benefits on a timely basis and at a sufficiently granular level, commensurate with the firm’s size, complexity, business activities, and overall risk profile.
- Methodologies: The FTP framework should be “transparent, repeatable, and sufficiently granular such that they align business decisions with the firm’s desired funding and contingent liquidity risk appetite.”7 The chosen methodologies should apply at the product and aggregate level and should measure costs and benefits of each business decision on the covered firm’s central funding and liquidity pools and its overall risk profile. For example, with respect to derivatives activities, the FTP framework “may consider the fair value of current positions, the rights of re-hypothecation for collateral received, and contingent outflows that may occur during a stress event.”8 Implementation: The FTP framework should be consistently applied across all aspects of the covered firm’s corporate structure to reduce the likelihood of “misaligned incentives.” The implications of any deviations from the framework should be analyzed and reported.
- Reporting: The FTP framework should provide for aggregation and reporting of FTP costs and benefits “at a frequency that is appropriate for the business line, product, or activity.” Although the guidance document does not proscribe a minimum reporting period, the Agencies note that month-end reporting may not “fully capture a firm’s day-to-day funding and contingent liquidity risks” and that trading exposures, in particular, should be assessed more frequently.9
- Principle Three: A firm should have a robust governance structure for FTP, including the production of a report on FTP and oversight from a senior management group and central management function.
- Management Review: A covered firm should designate a senior management group to oversee the FTP process. This group should include a “broad range of stakeholders,” including representatives of the covered firm’s asset-liability committee, treasury function, business lines, and risk management function.10 This management group should develop the policies and procedures underlying the FTP framework, should periodically review and update the basis for FTP methodologies (including upon material change in the covered firm’s structure or scope of activities), and, no less than quarterly, review reports on the framework’s implementation.
- Central management: A covered firm should establish a “central management function” to implement the FTP framework, to make and document all material approvals (including exceptions to the framework), and to produce and analyze reports on the framework’s implementation. The central management function’s reporting should be sufficiently granular (by business line, product, or activity level, as appropriate) to enable effective monitoring as part of the management review described above.
- Independent review: Internal audit, or another internal risk control function, should oversee the FTP process and report on whether the process appropriately reflects changing business and financial market conditions and aligns with the covered firm’s risk appetite. This function or another independent function should regularly review and validate internal risk models to ensure that they “continue to perform as expected, that all assumptions remain appropriate, and that limitations are understood and appropriately mitigated.”
- Principle Four: A firm should align business incentives with risk management and strategic objectives by incorporating FTP costs and benefits into product pricing, business metrics, and new product approval.
- Incorporation into day-to-day operations: A covered firm’s FTP framework should incorporate FTP costs and benefits into pricing, business metrics, and new product approval for all material business lines, products, and activities. The framework should provide business managers with sufficient and timely information to make these determinations.
- Decision making: Information provided to business lines may be either at a transaction level or at an aggregate level for “homogenous” transaction types. In making this determination, covered firms should consider any disadvantages to each approach. The Agencies note that, although transaction-level information may be more complex and costly, it provides a “more accurate risk-adjusted profitability” measure.11
- Incentives: Throughout the guidance, the Agencies stress that a covered firm should adopt an FTP framework that aligns business incentives with risk management objectives to ensure that “funding and contingent liquidity risks are being captured and are well-understood for product pricing, business metrics, and new product approval.”12 The Agencies note that business lines should understand the FTP framework and its implications for the business line.
EXAMPLES OF FTP METHODOLOGIES
The guidance document provides several illustrative examples of FTP methodologies for non-trading and trading exposures. The Agencies state that they will continue to monitor market practices and may update or add to the illustrative examples.
The Guidance comments that the FTP methodologies for non-trading exposures will vary based on the business activities and the firm’s specific exposures (for example, type of loans, deposits, and assets). The Guidance provides two illustrative examples of methodologies for non-trading exposures, including:
- Matched-Maturity Marginal Cost of Funding: Under this methodology, FTP costs of funds based on the covered firm’s funding mix, including long-term debt and alternative funding sources (FHLB advances and customer deposits), are allocated across business lines in a manner that incentivizes each line to generate stable funding by providing business lines with credits for providing stable funding. This methodology is designed to ensure that business lines are charged the cost of funding for the life of longer-dated assets. The Agencies note that cost of funds data should be derived from reliable and readily available data sources and should as closely as possible match the characteristics of the transactions or activities to which they are applied by incorporating holding periods, cash flows, re-pricing, prepayments, and expected life of the asset/transaction.
- As an example, the guidance considers a five-year commercial loan that is held to maturity with an interest rate that resets every three months. According to the Agencies, the interest rate component should be incorporated into the firm’s funding risk considerations as a threemonth exposure, whereas the loan’s presence on the covered firm’s balance should represent a five-year liquidity cost.
- Behavioral Assumptions for Contingent Liquidity Risk: A covered firm may create contingent liquidity risk models that are based on behavioral assumptions. For example, a covered firm may model the likelihood of a drawdown on a commitment based on “customer drawdown history, credit quality, and other factors” and may model deposits based on expected volatility and previous behavior.13
The guidance provides several FTP methodologies for trading exposures, but notes that the complexity of the adopted methodologies is dependent on several factors including the source of funding (secured vs. unsecured), the market liquidity of the exposure, the holding period of the position, and market conditions. For each of these methodologies, the Agencies stress that covered firms should analyze whether the adopted methodology misaligns risk-taking incentives and document such analyses in the report on FTP.
- Weighted Average Cost of Debt: This methodology utilizes the weighted average cost of outstanding firm debt, usually as a spread to an index, and applies this rate to the amount of an asset that is expected to be funded unsecured. This would include, for example, the spread between the value of the collateral to a repurchase agreement and the market haircut applied.
- Marginal Cost of Funding: This methodology considers the incremental unsecured borrowing rate of a firm and applies it to the amount of an asset to be funded unsecured.
- Liquid Asset Encumbrance Cost for Contingent Liquidity Risk: This methodology calculates the contingent liquidity risk of trading exposures by considering the unencumbered liquid assets that would be needed to cover any potential widening of market haircuts on secured funding. A covered firm may also include costs related to potential derivative outflows in stress market conditions. Any inconsistencies between the assumptions in this methodology and the covered firm’s internal stress testing should be clearly reported.