A bank's focal point for market risk: The transfer pricing mismatch unit

Journal of Bank Cost & Management Accounting, The, 2000 by Chittenden, John

SUMMARY

First we explore the mechanics of the transfer pricing Mismatch Unit and discuss the degree to which its P&L holds the Bank's profits from interest rate risk management. Then we discuss how the performance of this unit should be measured.

Interest rate risk (market risk) has not been a primary concern of U.S. financial institutions for the last several years. The money markets have been relatively calm and rate movements have been modest and gradual. In this environment many Banks have not focused much attention on this source of risk. Yet ALM and profitability reporting software have made considerable advances in providing more precise and timely information on the Banks' performance in controlling and profiting from market risk. This paper explores the primary mechanism for tracking the effectiveness of a Bank's market risk control: the performance of its transfer pricing mismatch unit.

DEFINITION OF THE MISMATCH UNIT

A Bank's Treasury department is usually a relatively small unit in terms of personnel and space occupied. In the cost allocation schema, it is more nearly comparable to the Summer Picnic Committee than to the Mortgage origination unit. On the other hand, the proportion of the balance sheet managed by Treasury can be very large, greater perhaps than any other single business unit's. Yet the true measure of Treasury performance must ultimately focus on its P&L ... its "bottom line" effect. Measuring Treasury performance through its P&L is not a simple matter.

As one begins to look into the mechanics of establishing management objectives and performance measurements for a Treasury department, he soon finds that what might sound straightforward at the outset soon becomes confusing and, like the pot of gold at the end of the rainbow, is easily seen from a certain distance but vanishes with proximity. In part, this is due to the many different, sometimes conflicting, objectives of a Treasury unit: liquidity management, investment for profit, funding, interest rate risk management, collateral management, and, perhaps, trading for profit. Of all these functions, probably the most unsettled in definition is the interest rate risk management as reflected in the transfer pricing Mismatch Unit and its relation to ALM hedging actions.

Matched term transfer pricing creates a "shadow" asset or liability for each expected cash flow on the balance sheet and attaches to each a market rate based on its term. Hence, we say "matched term" transfer pricing. Real assets are accordingly funded by "shadow" liabilities to produce a match-funded spread; conversely, real liabilities receive income from "shadow" assets for the same purpose. The offsets from these cost/credits for funds are posted to a single Treasury unit which holds all of them in one place and is thus "mismatched" except in the very improbable case that the Bank's balance sheet fortuitously has asset and liability cash flows which are exactly matched. This concept is illustrated in the simple "T" account diagram below:

This very simple Bank's mismatch position is illustrated again on page 6, where some term information has been added. The credit and funding spreads are provided by matched term funding and the Mismatch Unit holds the resulting position.

To see the effects of market rate movements on the mismatch position, consider the same simple balance sheet if rates move up 2% in the next month (shown in the table on page 7).

The Bank's total spread has declined from 6% to 4%, the full amount of which is reflected in the Mismatch Unit because it was caused by changing market rates.

In short, then, matched term transfer pricing pulls interest rate risk from the business units into the Mismatch Unit making the Mismatch Unit the true holder of the Bank's interest rate risk position. The Mismatch Unit's P&L is based solely on market rates absent the credit and funding spreads required by external customers. This concept is important. An example should clarify it:

The point here is that the Mismatch Unit holds only market risk profits or losses. It does not hedge credit spreads for the lenders nor does it hedge against retail deposit price erosion due to competitive pressures. These are line unit risks. The Mismatch Unit's profits are based solely on market rates.

The ALM department hedges the Bank's interest rate risk and therefore:

* changes the risk profile of the Bank's asset/liability mix,

* changes the volatility of its margin, and

* changes the Bank's profitability.

In doing so, it has these same three effects on the Mismatch Unit.

When the hedging results are posted to the Mismatch Unit and combined with the transfer pricing offsets, the Mismatch Unit becomes the sole measure of the Bank's market risk hedging programs. In this context one may legitimately say that ALCO policies which state ALM risk limits in terms of the Bank's net interest income are logically misapplied. The limits should be based on the Mismatch Unit's net interest income, which, as shown above, is based on market rates and is, therefore, the only amount that market hedging can address. Indeed, the emerging market for credit swaps may focus direct attention on credit spreads and ultimately compel many Banks to make a clear distinction between market risk profits and credit risk profits. We'll explore this topic in more detail below.