Where other banks may have more dynamics to consider and thus more components, the opportunity costs applied in the funds transfer pricing process must comprised out of the following minimum components:
- The fund transfer rate (FTR)
- The funding spread or liquidity premium (LP)
- The minimum reserve (MiRes)
And any additional product specific adjustments may make up the total of opportunity costs for that deal including an additional component called the expected risk margin (ERM) which I will talk about much later when we come to the topic of risk.
In addition, Basel 3 has added two new components to consider in light of the financial crisis of 2008. They are the liquidity coverage ratio (LCR) charge and a Net Stable Funding Ratio or the contingency liquidity buffer rate (CLP).
These six components and others ( which are too technical for this blog) make up the whole relative opportunity costs that banks must consider in order to price and assess the performance of most of their deals.
The fund transfer price rate (FTR), as I mentioned here, is the risk-less market rate at matching maturities, pricing terms and currencies. It is an alternative investment or refinancing in the money/capital market i.e. each balance sheet item is rated and assessed relatively with a risk less market rate.
In addition to this risk-less market rate, the funding spread, or LP, is a surcharge that makes up the part of the opportunity rate that aims to capture the refinancing cost and risk of a bank in regards to the maturity mismatch of the respective underlying deal and the currency of that deal.
It is a percentage rate per currency that depends on the refinancing conditions of a bank. A larger funding spread reflects a lower degree of accessibility of the currency for the bank or a less liquid market for that currency.
In any single deal, a bank must take into account that the currency of the funds used within that deal includes a future date where the deal will mature. Thus, the bank must make an estimated risk assessment of the future costs of having those funds at hand when the time comes to return a liability or fund an asset, i.e. cost of liquidity/funding spread.
The funding spread increases the deal’s margin on the liability side (reduction of refinancing costs as liquidity is created) and decreases the deal’s margin on the asset side (loans need liquidity).Thus, in that sense, the funding spreads can also function as a marketing tool or an incentive device to manage new customer deposits and also incentivize the sales of loan through its manipulation.
On the market there are different rates based on the pricing frequency of existing market deals where these deals are regularly re-assigned a price based on prior agreements.
All these components stem from the principle of opportunity cost and, at the end of the day, they all help determine the interest rate of the client (pricice the deal). Next I will elaborate on what happens with the cost of the minimum reserve and the CLP.