Bank CFOs, treasurers, and other senior managers are increasingly realizing that taking a closer look at the method of valuing their assets by jurisdiction — a process called funds transfer pricing (FTP) — can help solve liquidity problems within business units.
FTP involves calculating the value of each product offered in multiple jurisdictions, including, for example, the cost to fund loans. But the financial crisis turned some such calculations on their head, creating situations where the erosion of liquidity from one financial product could lead to inaccurate FTP for an entire firm.
How the valuation method is handled can have real-world implications for a bank’s liquidity. “We all saw the market failure [during the credit crisis] where the market was not [taking into account the pricing of] liquidity risk,” said Thomas Heffernan, managing director and treasurer of Mitsubishi UFJ Securities International, at an FTP conference this week produced by Marcus Evans. “It behooves corporations to monitor the performance [of securities and derivatives] but also charge appropriate levels of FTP for liquidity risk.”
Indeed, having the appropriate view of FTP is half the battle, continued Heffernan. “It’s no longer the case that liquidity costs and risks can be absorbed by treasury departments; they must be passed on to the businesses to help shape behavior and to properly measure performance,” he said.
More accurate pinpointing of FTP is taking on a higher priority at banks’ senior levels, a change that has come about predominantly since the credit crisis. FTP should be considered all the way up to the board level, Heffernan said, to avoid conflicts of interest among the treasurer, CFO, and other managers over how profitable a financial product or unit is.
To do that, banks increasingly need to adopt a global approach to FTP that is consistent across regions, several conference speakers said. Foreign-exchange risk is a particularly volatile gauge, they noted.
The added focus by management will be particularly important given the increased capital requirements for banks under Basel III, which is slated to start phasing in on January 1. As more capital requirements are placed on banks, an accurate measure of FTP is becoming crucial, the speakers said.
While most countries are aware of the importance of FTP, the United Kingdom, for one, stands far above the rest in encouraging firms to adopt more efficient FTP practices. In 2010 the U.K.’s Financial Services Authority (FSA) wrote a letter to corporate treasurers on how best to incorporate FTP in daily bank operations. The letter, whose instructions are still widely followed, noted that misappropriating FTP can “manifest itself in the conduct of loss-making business . . . and thereby [it] ultimately undermines sustainable business models.”
“The FSA will go up to a trader and say ‘What is your liquidity limit? What is your FTP if you breach your limit?’ to ensure liquidity risk management is embedded in the institution at all levels,” said Heffernan. “In the [United Kingdom], FTP is a regulatory requirement, but more companies need to make it a business requirement.”
Indeed, the FSA stated in its letter that while companies are making progress in addressing FTP shortcomings, there is more work to be done in attributing the costs, benefits, and risks of FTP to the appropriate business lines.
A similar sentiment is felt in the United States today. Mike Betty, senior vice president in treasury management and sales manager at North Carolina–based BB&T, noted that FTP is a challenge even for domestic banks like his that have sizable foreign-exchange operations.
“The question becomes, how do you appropriately assign FTP by individual person — by business line, by department, by asset, or by the credit rating of the company?” asked Betty. “We have to now figure out how to price FTP in countries we didn’t even know existed. Countries have different sets of rules and guidelines for FTP.”
Having near-real-time FTP should help to avoid some liquidity risks, noted both U.S. and foreign bank representatives. But currently even large global banks still perform stress testing on their liquidity positions on a month-over-month basis, with additional checks performed intramonthly, said one speaker.
The changing approach to FTP is, however, already making its mark on particular financial products. “FTP can drive a low-margin business like the repo [repurchase agreement] market out of business unless it evolves, and it [that market] is evolving to minimize liquidity risk in part because of FTP,” said Heffernan.