In the previous post we explored the concept of funds transfer pricing (FTP), but only on the surface level. Now for the good stuff: how should the FTP rate be assigned? Well, in a number of ways from the simple to the complex. Like a lot of things in life, simple means fast, easy, less data, good enough; whereas complex requires lots of patience and data for a little more accuracy.
"In the 1981 film, "Raiders of the Lost Ark", one particular scene consistently brings the house down: Indiana Jones, having survived an elaborate chase through a casbah, is confronted by a swordsman whipping through a flashy routine with a scimitar. Indy initially squares off against the deadly swordsman bearing only his trademark whip in his hands; then with a look of infinite fatigue and disgust, he casually pulls out his revolver and blows the bad guy away." (Credit for text: Snopes.com)
Yep, the 90s. It was all the rage and I jumped on board like a millennial on the Grateful Dead Fare Thee Well scene – I’m not sure what it’s all about, but I want to say I was there.
“Where is someone that will pay me 1.5X book?; that’s what my Interest Rate Risk model says my bank is worth.” That statement, along with “there is no way this bank could be sold for 1.5X book”, are two comments I’ve heard a few too many times lately from bankers and examiners. While I will let you figure out which group is responsible for each statement, both illustrate a somewhat common misconception that capital values (sometimes called “market value of equity”) from interest rate risk models are meant to reflect actual current and projected institution sales prices.
So if you’re reading this, my second ever blog post, you’ve probably already seen the first one entitled "Independent Review, Model Validation, and Backtesting: Same Thing, Only Different." In that piece, we looked at the interrelationship of these three items and brought up a few questions on backtesting. Specifically, we questioned who should do it, how often should it be done, what period should be covered, do you need to backtest model results and assumptions, and why even bother if market rates really aren’t changing.
In our ever increasing efforts to educate and inform, our marketing department here at team Plansmith has been on me to contribute to our Blog. Quite frankly, I’m not really a "blog" guy, but for those of you that know me, I’m not short on opinions either. So, given that I sit here stuck on a plane for a few hours, this seems like a good time to take a shot at it.
Gap, beta-adjusted gap, duration and even basic budgeting models only frustrate, confuse and even mislead the financial institution’s asset liability management committee (ALCO). Detailed gap analysis, fiddling with the distribution of savings balances and even calculating the duration of equity does not lead to better margins, nor do they mitigate rate risk.
Interestingly, the response I usually hear from small businesses (outside of the banking industry) is that they do have a strong, more formal handle on their day to day cash needs. They keep a check register (albeit mostly electronically, for example in QuickBooks). They know how much cash they need to fund their regular business needs and they monitor their cash flow in detail. They know which customers they need to collect from up-front, and which ones are slow to pay. They have concrete back-up plans if cash runs tight – savings, lines of credit, which bills they can delay paying versus which payments are critical to be paid on time. They know where they’ve been and where they’re trending - positive cash flow is critical to staying in business, so cash flow is always top of mind. Otherwise they’re out of business (and hence not part of my survey.)
Lately I’ve talked to a lot of bankers who are actually looking forward to the inevitable rise in market interest rates. They believe that their institution’s net interest margin and profit will increase because that’s what their rate risk analysis is telling them.
There is an architecture design concept that says, "form follows function." Once the ALCO has determined what it must do, it must inventory the resources at hand as well as those necessary to make it successful. Among these resources are the men and women within your company whose abilities and perspective will contribute to achieving the goal. It is safe to assume that the general purpose of the ALCO is to control the behavior of the net interest margin by understanding and controlling the factors that affect margin.