FTP in frontier markets - World Business Strategies in frontier markets Cert. BTRM Cohort 4, Lecture...

FTP in frontier markets

Cert. BTRM

Cohort 4, Lecture 18

17th August 2016

Massimo Pedroni

Partner, Head of International Business Practice,

Prometeia, London Office

BTRM Cohort 4 2016 2 © 2016 BTRM / Massimo Pedroni

C4 programme

Lecture 1 Primer on bank business model, financial statements and regulation

Lecture 2 Asset-Liability Management I: strategic ALM and balance sheet management.

Lecture 3 Asset-Liability Management II: banking products, interest rate benchmarks, FX hedging and NII/NIM management

Lecture 4 Basel III capital and liquidity rules

Lecture 5 ALM trading and hedging principles I: Money markets. ALM Simulation Game: introduction

Lecture 6 ALM trading and hedging II: Banking Book interest-rate risk management. Credit spread risk in the Banking Book

Lecture 7 Treasury Target Operating Model and reporting line. ALM and Hedge Accounting

Lecture 8 Asset-Liability Management III: The ALCO ToR / charter; ALCO sub-committee strucure. ALM Simulation game: discussion

Lecture 9 ALCO oversight of credit risk managment. Integrating ALM, Liquidity and Credit into ERM stress testing

Lecture 10 Capital market disciplines for bank issuers (AT1, T2, Secured, Unsecured). Impact of CCPs on ALM

Lecture 11 The mechanics of securitisation for balance sheet management

Lecture 12 Recovery and Resolution Planning

Lecture 13 Investor relations and the credit rating process

Lecture 14 Liquidity risk management I

Lecture 15 Liquidity risk management II: Risk metrics and limits; Collateral management and XVAs pt.1 (CVA, FVA)

Lecture 16 Liquidity risk management III: optimum liabilities strategy and managing the liquidity (HQLA) buffer; XVAs pt.2

Lecture 17 Constructing the bank internal funding curve

Lecture 18 Internal funds transfer pricing (“FTP”) and funding policies. FTP in frontier markets

Lecture 19 Liquidity reporting, stress testing and ILAAP. Intra-day liquidity risk. Asset encumbrance policy

Lecture 20 Capital management I: capital structure and planning

Lecture 21 Capital management II: capital strategy

Lecture 22 Principles of policy documentation: liquidity and capital. Compliance Principles. Exam Q&A session

FTP presents problems in curve

setting when dealing in “frontier”

markets with few external

reference points


The characteristics of «frontier markets»

With reference to the local currency..

Wholesale funding products are not available for banks: bonds issuances,

securitizations, syndicated loans simply do not exist

Interbank market is not liquid and limited to very short maturities (1w)

Derivatives are not traded, even in the OTC markets, with the exceptions

of few FX contracts (CCS or Forwards)

Central bank refinancing is limited to very short maturities

The funding structure is mostly (or entirely) represented by retail deposits

A large portion of assets is represented by (local) government bonds

(with m/t maturity), since the mortgage business is not well developed

With reference to the foreign currencies (USD and Euro in particular)..

These constrains might be overcome by accessing the international

markets, even if this is rarely possible (in particular for non tier 1 banks)

due to specific (e.g. lack of rating) or systemic factors (e.g capital control)


The typical balance sheet in frontier markets

In order to illustrate the peculiarities of FTP process in frontier markets, the

following simplified balance sheet will be used in a case-study:

100%

Securities

100%

Customer

Deposits

Balance sheet

Typical situation in

frontier markets:

customer deposits

are largely invested in

government bonds

and treasury bills

Typical situation in

frontier markets:

the liability structure

is mostly (or entirely)

represented by

customer deposits

This simplified balance sheet allows to discuss:

a) the importance of FTP for assessing and allocating the risk and profitability originated

by the two sides of the balance sheet

b) the alternative approaches for building the FTP curve in frontier markets

c) the application of the target methodology for quantifying the drivers and components

of FTP in frontier markets (FTP Base Rate and FTP Funding Spread)


Interest Margin from accounting perspective

From a simple accounting perspective, the Interest Margin is the difference

between interest received on assets and interest paid on liabilities

This information does not answer

some key questions:

Is the Net Interest Margin generated

on the asset side, on the liability side

or on both?

How much of the Margin is generated:

• by Unit "A" holding the bond?

• by Unit "B" collecting the

deposit?

In order to measure the individual

performance of lending and funding

transactions, we need to introduce

“internal” rates to identify and allocate

a “virtual” interest component

1,15%

B – Deposit

3 months

4,50%

Net

Interest

Margin

5,65%

A – Bond

5 years

3 months 5 years

Inte

rest

rate

s

Accounting view

(simplified)

Maturity dates


Interest Margin from managerial perspective

3 months

FTP In

tere

st

rate

s

5 years

FTP

Lending

mark-up

ALM

spread Funding

mark-

down

FTP

4,50%

Net

Interest

Margin

3 months 5 years

Inte

rest

rate

s

3 months 5 years

FTP Curve

1,15%

B – Deposit

3 months

5,65%

A – Bond

5 years

Maturity dates Maturity dates

The FTP curve allows to split the Accounting Margin into three basic

components: Funding Mark-down, Lending Mark-up, ALM Spread

Managerial view

(FTP margins - simplified)

Accounting view

(gross margin - simplified)


The NII allocation based on FTP margin

Bond Rate

Lending

margin Credit and

operational

risk costs

Funding unit

ALM

margin

NII

Treasury Lending unit

Funding Rate Bond Rate

Funding

mark-down

Lending

mark-up ALM spread

Net Interest Income – Bank level breakdown

Funding

Rate Deposits FTP Bonds FTP

Industrial

Costs

Industrial &

Operational

Risk Costs

Funding

margin

The Net Interest

Income of the bank

can be allocated to the

various BUs in order to

measure the relate

profitability and support

risk-based pricing


Which FTP curve for a frontier market?

Introducing the FTP curve enables to represent, for each maturity, the

price at which:

The FTP curve plays a crucial role, since it splits the interest Margin

between the deposit and the bond, that is to say the separation of NII

between Unit "A" and Unit "B"

long term asset positions –

such as bonds – can be

virtually transferred to the

Treasury and funded.. ..by short term liability positions –

such as deposits –, which can be

virtually transferred to the Treasury,

invested and remunerated

according to their maturity

Deposit FTP

Bond FTP

FTP Curve


Funding cost versus investment return view

The FTP reflects the Interest and Liquidity Risk profiles of each transaction,

based on its financial characteristics

Two opposite perspectives can be used to set the FTP:

1. What is the marginal cost of the funds used by the business?

the FTP is the price paid for the liability, represented only by a customer deposit

in our case study

the FTP curve is built on the deposits curve, whenever it is possible, to

differentiate maturities and extrapolate term points. However, since customer

deposits are usually offered to short maturities only (typically up to 6 months), a

flat “pool rate” is commonly used (representing the average cost of funding for

the Bank)

1. How much the bank can earn from its available funds?

this is the return of its assets assuming that no extra (credit) risk is taken

in our case study, the FTP curve is built on the government bonds curve


Alternative methods to set FTP rates

Based on the two approaches previously described, three potential

methods can be explored for building the FTP curve in frontier

markets:

Actual funding rates: average funding cost of

the customer deposits (on the liability side)

Actual investment rates: yield curve of the

government bonds (on asset side)

Blended curve: mix of both pricing drivers,

based on a predefined “blending” mechanism

(still to be defined..)


1st method: FTP based on actual funding cost

The first method for building the FTP curve is to use retail funding rates

(i.e. average actual cost). Given the short maturity of customer deposits,

a proper yield curve cannot be built up and a unique “pool rate” is used

1,15%

3 months FTP

Inte

rest

rate

s

1,15%

5 years FTP

4,50%

Lending

mark-up

0,00%

Funding

mark-down

3 months 5 years

Maturity dates

FTP Curve = pool rate 1,15%

B – Deposit

5,65%

A – Security

0,00%

ALM

margin

In our case study:

Unit "A" borrows from Treasury

at an internal pool rate,

obtaining a mark-up of 4,50%

Unit "B" lends to Treasury the

funds raised with the deposit at

the same pool rate, obtaining a

mark-down of 0%.

This method entirely

compresses the margin on the

liability side, showing that retail

funding is not a profitable BU


1st method: PROs and CONs

PROs:

Does not reflect any external benchmark or market conditions

Auto-referential rates, which rely on actual costs of the bank’s funding to

measure the profitability of the bank’s positions including the liabilities

As a result, the method does not allocate any profitability to customer deposits

Does not take into consideration time premium and liquidity premium over the

various maturities, since the FTP curve is here a flat “pool rate”. This is

calculated as weighted average of customer deposits rates, that are typically

short term and not differentiated by maturity (mostly 1 to 6 months in general)

Does not represent the margin of the maturity transformation of the bank but

instead allocates all the entire benefit to the commercial mark-up.

Reflects the funding structure of the banks in frontier markets, mainly composed

of customer deposits

Very closed to the actual cost that will be born by the bank for getting extra

funding to finance new transactions (also considering that the bank does not

require wholesale borrowing).

CONs:


2nd method: FTP based on Govies yields

2,55%

3 months FTP

Inte

rest

rate

s

5,65%

5 years FTP 0,00%

Lending

mark-up

3,10%

ALM margin

1,40%

Funding mark-down

3

months 5 years

FTP

Curve

1,15%

B – Deposit

5,65%

A – Security

Maturity dates

The second method for building the FTP curve starts from government

bonds rates, which are assumed to be the unique form of “risk free”

investment for the Bank’s (excluding the sovereign risk)

In our case study:

Unit "A" borrows from

Treasury at an internal

transfer rate consistent

with the 5 years maturity,

obtaining a mark-up of 0%

Unit "B" lends to Treasury

for 3 months, obtaining a

mark-down of 1,40%.

This method entirely

compresses the margin on

the asset side, showing T-

bonds as non profitable


2nd method: PROs and CONs

PROs: Provides a market anchor, using rates regularly quoted and published. This is

always recommended in order to meet some FTP golden rules:

risk neutrality: transferring the risks embedded in the units’ portfolios through internal

hedging transactions at zero cost for the parties

transparency: money and capital market rates, when expressed by a liquid, efficient

and regulated market, represent the best benchmark for internal or external pricing

margin stability: in particular for the transactions correlated to market parameters

Wholesale rates representing the marginal cost for getting extra funding at

current market conditions

Provides a term structure with rates differentiated by maturity

CONs: Does not take into consideration the funding structure of the bank, mainly (or

even entirely) composed of retail deposits

Does not allocate any profit to government bonds, the main form if investment

Most asset positions appear unprofitable when they have a rate equal or lower

than government bonds rates, even if they contribute positively to the Net

Interest Income having a return higher than customer deposits


3rd method: the “blended” curve

Inte

rest

rate

s

Maturity dates

Retail “pool” rate

Wholesale government bonds curve

FTP blended curve

The two previous approaches turn out to be sub-optimal for the bank

Given the peculiarities of frontier markets – typically driven by customer

deposits invested in treasury bonds – these two approaches do not allow

to split the Interest Margin the two sides of the balance sheet

An alternative method for

building the FTP curve is to use

a combination of both

government bonds and retail

funding rates

• The actual cost of funding can be

extrapolated by both markets,

according to the funding mix

(wholesale / retail) that the bank

is expected to have at the

moment at which the FTP is

defined


How to blend the FTP curve

Definition of

market

curves

Calculation

of the

blending

rates

Definition of

a «blended»

FTP curve

Extrapolation of the reference

curves for both markets.

Data are based on current rates

for customer deposits and

government bonds

Funding composition (in %) is

calculated:

by bucket/maturity;

by stock/flows (marginal)

70%

30%

wholesale funding portion

retail funding portion

The blended curve is the

weighted average of the

wholesale and retail curves

based on the funding mix.

Inte

rest

rate

s

Maturity dates

retail funding

wholesale funding

Example:

Inte

rest

rate

s

Maturity dates

retail funding

wholesale funding

blended curve

70% weight

30% weight

E.g. 70% * wholesale + 30 % * retail


..and when wholesale funding is inexistent?

Given the high incidence of retail deposits in the balance sheet of the banks

located in frontier markets, it is not possible to use the current or expected

funding mix. Instead, the following assumption can be made:

• the bank primarily relies on the “attrition” of its core deposits to fund new

assets, even for the longer maturities, leveraging on deposits’ behavioural stability

• the volume which cannot be covered by stable funding sources is

“fictitiously” financed in the wholesale market, which is assumed to be the only

available source of funds for medium-long term assets

The first assumption is reasonable:

the persistence of retail funding is

statistically proven, even in times of

crisis

it is fair that all business units benefit

from the lower cost of customer liabilities

The second one is not realistic but conservative:

it is not prudential to assume that long term

assets are only funded by retail funding

it is fair that all business units sustain the

“fictitious” cost of wholesale funding, even if

this will be never sustained by the bank


The blending process in frontier markets (1/4)

1M 2M 3M 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y … 30Y

FUNDING NEED

ASSET SIDE

TERM

DEPOSITS

Retail Funding

Weight

100%

80%

50%

5%

For each time bucket, from 1D to the last term point of FTP curve, the

weighting factor is defined as the percentage of new transactions assumed to

be funded by retail deposits. From a contractual standpoint, the maturity of term

deposits usually spans from 1M to 6




FUNDING NEED

TERM

DEPOSITS Attrition curve

However, the contractual profile should be adjusted in order to reflect the

empirical duration of customer deposits, which represent a stable source of

funding even for long term maturities. This allows to calculate Retail Funding

Weights which take into consideration the real profile of customer deposits

15%

10%

8%

7%

20%

18%

17%

16%

60%

50%

40%

30%

100%

95%

80%

70%

6%

4%

2%

0%

ASSET SIDE




ASSET SIDE

15%

10%

8%

7%

20%

18%

17%

16%

60%

50%

40%

30%

100%

95%

80%

70%

6%

4%

2%

0%

FUNDING NEED

TERM


The residual part of the volume is assumed to be funded in the wholesale

market. This hypothesis is based on two main rationales:

assuming that customer deposits can fund 100% of new assets would not be prudential from a risk

perspective (and not consistent with Basel 3 guidelines)

assuming that 100% of assets are funded by deposits’ roll-over would introduce concentration risk.


15%

10%

8%

7%

20%

18%

17%

16%

60%

50%

40%

30%

100%

95%

80%

70%

6%

4%

2%

0%

FUNDING NEED

TERM


1M 2M 3M 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y … 30Y Inte

rest

rate

s

retail funding curve (flat “pool rate”)

wholesale funding curve (*)

FTP blended curve

wholesale

weight

retail

weight


(*) The wholesale curve is assumed to be

equal to the Govies yield curve, shifted by a

convention number of basis points


BUs margins with a blended FTP curve

1,75%

3M FTP

Inte

rest

rate

s

5,35%

5Y FTP

0,30%

Lending

mark-up

3,60%

ALM

margin

0,60%

Funding mark-down

3 months 5 years

FTP

Curve 1,15%

B – Deposit

5,65%

A – Security

Maturity dates

Bond Curve

In the blended model:

Unit "A" borrows from Treasury at an

internal transfer rate consistent with

the 5 years maturity, obtaining a

mark-up of 0,30%

Unit "B" lends to Treasury the fund

raised with the deposit for 3 months,

obtaining a mark-down of 0,60%

The low mark-up on the asset

side is consistent with the

relatively low risk of the security

The mark-down on the liability

side is consistent with the

assumption that funding stability

generates value for the bank

The high ALM margin reflects

the 3M-5Y maturity mismatch


Advantages of the Blended Model

REFLECTS CAREFULLY THE

BANK’S FUNDING STRUCTURE

ANCHORS THE FTP TO

MARKET CONDITIONS

Changes in market rates are

reflected in the «blended» curve

(and then in final FTP)

depending on the frequency and

granularity of data observation

Changes in business model (product

composition) impact the expected

funding mix (retail / wholesale), not

only in terms of volumes but also in

terms of (behavioural) maturities

+


Multiple choice questions (1/2)

What are the main constrains that frontier markets face in building an

FTP curve?

a) lack of wholesale funding products to be used as benchmark prices, in

particular for long term maturity

b) lack of Government bonds in local currency

c) overreliance on interest rates derivatives to hedge fixed rate products

d) currency pegging, usually to US Dollar or Euro


Multiple choice questions (2/2)

What is the industry best practice for building a consistent FTP curve in

frontier market?

a) using the actual funding costs, essentially driven by retail deposits, to

calculate a unique “pool rate”

b) using the government bonds curve, assuming this is the only reasonable

proxy of risk-free rates

c) blending the retail and wholesale funding costs, assuming a certain funding

mix for the various maturities, in order to set a benchmark that allocates

appropriately the profitability between asset and liability side

d) taking the swap rates for US or Euro and covert them in local currency,

making some judgmental assumptions about forward FX rates


Additional reading

See Student Handbook

No public documentation is available on this specific topic.. only the

experience of the few consultants involved in this pioneering project!

Email: [email protected]


DISCLAIMER

The material in this presentation is based on information that we consider reliable, but we do not

warrant that it is accurate or complete, and it should not be relied on as such. Opinions expressed

are current opinions only. We are not soliciting any action based upon this material. Neither the

author, his employers, any operating arm of his employers nor any affiliated body can be held liable

or responsible for any outcomes resulting from actions arising as a result of delivering this

presentation. This presentation does not constitute investment advice nor should it be considered

as such.

The views expressed in this presentation represent those of Massimo Pedroni in his individual

private capacity and should not be taken to be the views of any employer or any affiliated body,

including University of Kent or WBS, or of Massimo Pedroni as an employee of any institution or

affiliated body. Either he or his employers may or may not hold, or have recently held, a position in

any security identified in this document.

This presentation is © BTRM / Massimo Pedroni 2016. No part of this presentation may be

copied, reproduced, distributed or stored in any form including electronically without express

written permission in advance from the author.

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