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Transfer pricing: Pitfalls in using multiple benchmark yield curves Shih, Andre Today most banks clearly understand the need to segregate interest rate risk from the operating results of line units. And most are instituting transfer pricing systems to accomplish this objective. Instituting a transfer pricing program, however, will not guarantee that a bank will actually succeed in isolating interest rate risk. The specific transfer pricing methodologies that the bank chooses can have far-reaching implications for the effectiveness of its program. One of the key methodological choices that banks currently face is the decision to employ single or multiple benchmark yield curves. (At many institutions these yield curves are referred to as funding curves.) This paper will demonstrate that, while the multiple curves option may appear desirable at first glance, the actual use of a multiple-curve methodology will have serious and detrimental consequences for the transfer pricing program. The most serious of these include: * Misallocation of resources; * Inconsistent margin comparisons among products; * Inaccurate measurement of the total interest rate risk of the institution; * Improper inclusion of credit risk in interest rate risk. If left uncorrected, these deficiencies will in turn lead to such serious practical consequences as inaccurate hedging, incorrect measurement of treasury/funding center performance, and product mispricing. The negative impact of multiple benchmark yield curves will ultimately pervade many different aspects of profitability and risk management. The process is similar to compressing a balloon; when we squeeze down on one end, the other end distorts or ruptures. We need to keep in mind the stated objective for the transfer pricing process, namely, to provide an accurate understanding of the net interest margin contribution to profitability for any dimension we want to measure, such as product, business unit, or customer. Accurate transfer pricing removes interest rate risk from the line operating units, which have no control over the interest rate environment, and centralizes the risk in a funding center that is usually a unit within the Treasury. It thereby enables the bank to measure the actual operating performance of its various business elements in more accurate and productive ways. Because it is a critical factor in the measurement of net interest margin contribution, the transfer pricing process has far-reaching impact on all decisions driven by profitability-based performance measures, from product pricing through customer relationship management. It will ultimately influence all dimensions of resource allocation, including decisions on customers and distribution channels as well as products.

Exactly what constitutes interest rate risk can be a source of confusion at some institutions. Line units can and do affect the repricing characteristics of products with "administered rates" (such as credit cards and interest-bearing checking accounts) by changing pricing strategies in response to shifts in market rates. In these cases, transfer pricing assumptions about margins should be adjusted to take pricing responses and customer reactions into account. But we should not confuse control over prices with control over the interest rate environment itself. Line units will have no control over the latter unless they institute hedging programs of their own. Properly implemented, transfer pricing allows an institution to decompose the contribution to net interest margin into loan contribution, deposit contribution, and interest rate risk proper. A simple example will illustrate how this process allows an institution to measure profit correctly. Assume that an institution has only two items on its balance sheet: a 2-year duration deposit on which it pays a 6.5% interest rate and a 7-year duration mortgage on which it receives a 10% interest rate. Together, the two instruments yield a net interest margin of 3.5% (10%-6.5%). Assume further that the institution is asset rich and can borrow in the wholesale market at 7% for 2 years and 8% for 7 years. Figure 1 shows how transfer pricing allows the institution to decompose its 3.5% net interest margin into a 2% net interest margin on loan (10%-8%), a 0.5% net interest margin on deposit (7%-6.5%), and an interest rate risk mismatch of 1% (8%-7%). The example makes it clear that the bank needs a benchmark in order to identify the different contributions of loans, deposits, and interest rate risk. Institutions that have excess deposits tend to select a marginal investment curve for their benchmark. Institutions that need to meet marginal funding requirements with wholesale borrowing usually select a marginal borrowing (or funding) curve. Note that the operative word here is marginal. For an asset rich institution, marginal refers to the rate the bank would pay to borrow the next increment of funding in the market. The market of reference will usually be the wholesale market, since the institution would presumably exhaust other and cheaper funding sources first. Note also that average cost would not be a meaningful concept in this context. An institution cannot borrow on an average funding cost basis; it can borrow only at the market rate currently available to institutions with its particular credit rating (the marginal funding cost). The choice of the proper cost of funds benchmark is a critical one since it determines how profitability contributions to net interest margin are measured. If the bank sets the benchmark cost of funds higher, it will lower the profitability contribution of loans and increase the profitability contribution of deposits. It is clear that a benchmark cannot be arbitrary, but must be market determined. No other mechanism would ever gain acceptance with business managers whose profit results and performance ratings are being affected. Once an institution has gotten this far in the transfer pricing process, it faces a subtle danger. Its financial analysts have convinced its senior executives and line business managers that accurate transfer pricing is essential to the proper and precise measurement of profit contributions. Can the institution not gain even more precision by selecting individual benchmark curves for each type of product or business line? Some institutions have decided to try this approach. It is not unusual, for example, to see institutions select a mortgage curve to transfer price mortgages while using the institution's wholesale funding curve for all remaining assets and liabilities. Mortgages are especially appealing candidates for separate benchmarks since these assets have counterparts, such as mortgage portfolios and mortgage-backed securities, which are openly and widely traded in financial markets. Hence, special cost and price information is readily available. Mortgage products may also present unique features, such as embedded options, that seem to demand the use of a separate, specialized funding curve. Some analysts have argued that the FHMLC borrowing cost should be used to transfer price all mortgages, while a marginal wholesale funding curve should be used for all other items. Some others argue that the FHMLC investment rate should be used, which raises a number of other issues that will warrant a separate article. THE HIDDEN IMPACT OF MULTIPLE YIELD CURVES

Arguments like these appear very convincing, especially when applied to assets like mortgages. But the hidden consequences of this multiplecurves strategy can be both detrimental and far reaching. The first and most obvious consequence is that the strategy undercuts the foremost objectives of transfer pricing: the proper measurement of business performance independent of interest rate risk and the corresponding centralization of interest rate risk measurement and management within a funding center. Specifically, once multiple curves are introduced into a transfer pricing system, the total spread in the funding center's funding books can no longer be interpreted as representing the institution's total interest rate risk. In addition, the financial results of the interest rate risk center can no longer be interpreted as measuring the institution's success in controlling interest rate risk. Most importantly, the institution will now have altered its measurement of net interest margin contribution in significant ways. The following simple example demonstrates these hazards. Assume an institution has a very simple balance sheet with one asset and one liability. Let us assume further that both items are bullet securities of equal duration, say five years. This institution is perfectly matched and thus should not have any interest rate risk at all. Its funding center should show a net interest margin of zero. For example, let us assume that the 5-year loan earned a rate of 9%, the 5-year deposit paid a rate of 7%, and the institution could borrow for 5 years at 7.5% based on its wholesale funding curve. As Figure 2 shows, the 2% net interest margin (9% - 7%) of the institution can be decomposed into an asset net interest margin of 1.5% (9% 7.5%), a liability net interest margin of 0.5% (7.5% - 7%) and a zero interest rate risk (7.5% - 7.5%). Note, however, that when the benchmark yield curve used to transfer price the asset differs from the curve used to transfer price the liability, the funding center will show a net interest margin contribution equal to the difference between the rates of the two benchmark curves at the five-year point. Going back to the example above, let's assume an alternate case where the institution elected to use a mortgage funding curve for the loan while using its wholesale funding curve for the deposit. Assume further that the 5-year mortgage agency borrowing cost was at 8.1 %. How would the 2% net interest margin be decomposed when applying these two different transfer pricing curves? As Figure 3 shows, the net interest margin on the asset has now decreased from 1.5% to 0.9% (9%-8.1%). The liability net interest margin remains unchanged at 0.5% (7.5%-7.0%). The remaining difference of 0.6% now resides in the funding center and represents the differences between the two transfer pricing curves at the 5-year point (8.1% - 7.5%). This misleading result clearly distorts the institution's real position. Unless the institution has the ability to isolate the effects of the differences between the two curves and adjust for the discrepancy, it will not be able to identify its true interest rate risk, much less measure its success in controlling that risk. A second and equally serious consequence of a multiple curves strategy is that it may effectively mix interest rate risk with credit risk. Different benchmark curves are very likely to represent different underlying credit risk profiles. A mortgage curve, for example, will reflect the credit risk of either the underlying mortgage instruments or the mortgage agency. A wholesale funding curve, by contrast, will reflect the institution's own credit risk. Unless the two are exactly equal, the differential in credit risk will be posted to the funding center as interest rate risk, and the funding center may expend money and energy to hedge exposures that really represent credit risk. There is an even more subtle source of error that can occur when institutions use mortgage agency borrowing costs as a benchmark. Fannie Mae, for example, enjoys a higher credit rating than many commercial banks, and its lower borrowing costs reflect its higher credit rating. An institution that uses Fannie Mae borrowing costs as the benchmark yield curve for its mortgage funding is confounding Fannie Mae's credit position with its own. A third deleterious effect of the multiple curves approach is that it creates inconsistencies in net interest margin. The net interest margin contributions of securities transfer priced with one benchmark yield curve are no longer

comparable with those transfer priced with a different benchmark yield curve. We are quite literally measuring net interest margin contributions with two different yardsticks. Although it is legitimate to use different benchmark curves for different purposes, it is improper to pursue two different purposes simultaneously. For results to be meaningful, a given yardstick selected for a given purpose should be applied consistently throughout the transfer pricing process. A bank cannot apply one yardstick to one subset of business and a second yardstick to another subset, and then consider the results comparable. The confusion can grow particularly acute when we consider securities with embedded options. The market prices of these securities will generally vary with interest rates shifts. Some analysts have suggested that the use of multiple curves will allow an institution to capture these shifts in market price. The objection to this practice is a simple one. There are more straightforward and accurate tools available for capturing this risk, and they do not introduce the problems associated with multiple curves. When embedded option risk is an issue, institutions should develop a separate estimate of the option using a stochastic option valuation tool with parameters calibrated to market prices. Otherwise, mixing of credit rate risk with rate risk will persist, and net interest margin contributions will not be comparable. Please note that the arguments we are setting forth do not apply to the use of multiple benchmark curves to transfer price balance sheet items in different currencies. Each currency in which a bank deals represents a distinct and independent source of interest rate risk. Interest rates in Germany or Chile may shift in opposite directions for completely unrelated reasons. It is, therefore, entirely appropriate for a bank to apply a separate benchmark yield curve to each of the currencies in which it operates. The deleterious effects of multiple benchmark curves may seem academic at first glance, but their actual consequences are not trivial. There are at least five points at which the use of multiple transfer curves can introduce error or inaccuracy into an institution's risk management practices. The cumulative effects of these errors can significantly affect the institution's overall profit performance. Systematically Misdirected Focus and Performance Incentives The introduction of error into interest rate risk measurement, and subsequently into pricing and profitability decisions, initiates a chain reaction that can affect structures as distinct as the performance incentive system. Institutions will make resource allocation decisions based on incorrect information. They may well end up selling the wrong products, forfeiting proper (and attainable) returns, and pricing products out of the marketplace. And they may seriously misjudge the impact of their decisions on customer relationship management and distribution channel mix. The cumulative effect of these influences can be a systematic misdirection of business focus brought about by errors in performance evaluations and counterproductive performance incentives. When tainted results from the transfer pricing system are used for managing the operations and risk of the business, the use of multiple benchmark yield curves will ultimately lead to serious, enterprise-wide misallocation of resources. In financial institutions, decision-making is a complex process that depends on an extensive web of information relationships. It is therefore critical that an institution identify all the ramifications that a technique or method will have for downstream decisions. Introducing errors at any one point is like pressing down on any point on the surface of a balloon. We can be certain that our error will pop up at some other point on the surface. Incorrect Hedging

If the results of the funding center do not accurately reflect the total interest rate risk of the institution, any attempt to hedge interest rate risk based on funding center measures will by definition prove incorrect. In the worst case, a "hedging" program could exacerbate the interest rate risk of the institution if the measurement process yields a risk position opposite to the true rate risk position of the institution. In addition, the costs of incorrect hedging could become very significant. Improper Interest Rate Risk Performance Measurement If the measurement of interest rate risk is inaccurate, the institution will not be able to measure the effectiveness of its hedging policy accurately. The historical performance of the funding center may reflect a number of factors other than interest rate risk. An institution might abandon genuinely successful strategies or, in the worst case, persist in strategies that are actually unprofitable. Mispricing If inaccurate risk measures are used in pricing decisions, then the effects of the inaccuracies may be amplified throughout the enterprise. The institution may, for example, use its interest rate risk measures to help decide whether it should provide a given product. Profit margins on most banking products are generally very thin, and small errors in interest rate risk measures could produce significant swings in perceived profitability. Bad pricing decisions will reduce stockholder value as surely as bad credit decisions. Consider one brief example. Most bankers agree that institutions should shy away from offering competitivelypriced products that have less credit risk than itself, since those would tend to be uneconomical by definition. For example, consumer finance companies tend to have low credit rating due to the higher credit risk characteristics of their borrowers. As a result, their borrowing costs tend to be higher than those of traditional retail banks. These finance companies would experience negative spreads if they invested in the highest rate investment grade securities. The use of a funding curve that does not reflect the institution's true credit risk, such as the use of FHMLC borrowing costs mentioned above, will prevent an institution from properly identifying such cases. Pricing based on such curves will also be flawed. Incorrect Capital Attribution Best practice institutions tend to develop their capital attribution estimates by decomposing capital requirements according to sources of risk: credit, interest rate, operational, and so forth. As we noted, the use of multiple curves often mixes credit and interest rate risk. Such mixing leads to improper estimates of the volatility of the funding center and, consequently, of the capital required for interest rate risk. Some institutions that have linked measurement and goal setting have understood that they must adjust for the impact of multiple curves in order to encourage proper behavior. They have elected to adjust their performance measures by such methods as changes in hurdle rates and capital allocations. Such approaches tend to be messy, and they require intensive maintenance in the form of the multiple analytical processes needed to track impacts accurately over time. Some observers may argue that transfer pricing is really a zero-sum game, a means of decomposing a net interest margin total which will remain constant regardless of the methods we use to carve it up. If we look only at the mechanics of the transfer pricing process, this literal characterization is certainly true. But almost every institution that uses a transfer pricing system takes the process further. The results of transfer pricing calculations are net interest margin contribution figures, which are often used to measure and evaluate performance as well as to support the decision-making process. These results are also used to determine provisions of the incentive system. Under these circumstances, transfer pricing directly affects employee behavior, and thus has real impact on all the

operations of the institution. Seen in this light, transfer pricing is not just a method for slicing up the net interest margin pie, it also plays a material role in determining how large the pie will be. *Reprinted from Journal of Bank Cost & Management Accounting, Volume 11, No. 2. At time of original publication, Andre Shih and Steven Wofford were Directors of Treasury Services Corporation, Los Angeles, California, and David Crandon was a Vice President of Management Science Associates, Pittsburgh, Pennsylvania. By Andre Shih, David Crandon, and Steven Wofford* Copyright National Association for Bank Cost & Management Accounting 2000 Provided by ProQuest Information and Learning Company. All rights Reserved