Transfer Pricing for Financial Institutions

Transfer pricing for financial institutions

Transfer pricing for financial institutions John Smullen

WO O DH EA D PU B LI SH I NG LI M ITE D Cambridge England

Published by Woodhead Publishing Limited, Abington Hall, Abington Cambridge CB1 6AH, England www.woodhead-publishing.com First published 2001, Woodhead Publishing Ltd # 2001, Woodhead Publishing Ltd The author has asserted his moral rights. This book contains information obtained from authentic and highly regarded sources. Reprinted material is quoted with permission, and sources are indicated. Reasonable efforts have been made to publish reliable data and information, but the author and the publisher cannot assume responsibility for the validity of all materials. Neither the author nor the publisher, nor anyone else associated with this publication, shall be liable for any loss, damage or liability directly or indirectly caused or alleged to be caused by this book. Neither this book nor any part may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, microfilming and recording, or by any information storage or retrieval system, without permission in writing from the publisher. The consent of Woodhead Publishing Limited does not extend to copying for general distribution, for promotion, for creating new works, or for resale. Specific permission must be obtained in writing from Woodhead Publishing Limited for such copying. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation, without intent to infringe. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library. ISBN 1 85573 372 2 Cover design by The ColourStudio Typeset by BookEns Ltd, Royston, Herts Printed by Victoire Press Ltd, Cambridge, England

I would like to dedicate this book to my wife and my mother: most of the good things I have done in life are the responsibility of one or the other

Contents Preface

xi

PART 1: AN INTRODUCTION TO TRANSFER PRICING IN FINANCIAL INSTITUTIONS

1

1.

What is transfer pricing?

3

Introduction

3

The definition of transfer pricing

3

Motives for transfer pricing

4

The focus of the book

7

The general theory of transfer pricing

8

Introduction

8

The economist's perception of optimal transfer prices

8

2.

3.

4.

Comments on the simple optimal pricing model

13

Transfer pricing: the accountant's perspective

15

Conclusions

17

Transfer pricing in commercial organisations

18

Introduction

18

Single country transfer pricing systems

19

Multinational transfer pricing practices

19

Comments on transfer pricing experience

19

The uses of transfer pricing in financial organisations

21

Introduction

21

The nature of transfer prices

21

Uses of transfer pricing

22

Different types of transfer price

30

Conclusions

32

vii

CONTENTS

PART 2: SETTING TRANSFER PRICES IN FINANCIAL INSTITUTIONS

33

5.

Integrating transfer prices with organisational structure

35

Introduction

35

Financial information: the strategic perspective

35

The interrelationships of units

37

Conclusions

39

Attitudes to risk

40

Introduction

40

The traditional view of risk

40

Market-based attitudes to risk

43

Conclusions

48

6.

PART 3: SPECIFIC TRANSFER PRICES

51

7.

Transfer prices based on operating expenses

53

Introduction

53

The principles of activity-based costing

53

The distinction between transfer pricing and cost allocation

56

Problems in using activity-based costing information as part of a transfer pricing system

8.

9.

viii

56

The uses of cost-based information for transfer pricing

57

Conclusions on the use of costing information

58

Comparing financial and non-financial organisations

58

Transfer pricing the cost of funds: a general perspective

59

Introduction

59

Borrowing and lending, investing and funding

59

Transfer pricing and time

63

Comments on transfer pricing

64

Conclusions

65

The transfer price of funds: some perspectives on wholesale and retail funding

66

Introduction

66

To what extent are wholesale and retail funding equivalent?

66

Price making

67

Effective duration of funds

68

CONTENTS

10.

11.

12.

Differences between wholesale and retail customers

69

Discontinuities in wholesale funding

69

Conclusions

70

The transfer pricing of capital

71

Introduction

71

Capital as funding

72

Regulatory capital

74

Capital at risk

77

Conclusions

78

Risk adjusted performance measures: the transfer price of investment portfolios

79

Introduction

79

General issues in relation to RAPMs

81

The measures

82

Problems with the measures

88

Conclusions

89

Risk adjusted performance measures: return on risk adjusted capital and associated measures

13.

14.

90

Introduction

90

RORAC

90

Evaluation of RORAC style measures

92

Is the RORAC approach totally misplaced?

96

Conclusions

96

Risk adjusted performance measures: a critical overview

97

Introduction

97

RAPMs and investors' desires

97

RAPMs as statistics

100

RAPMs and incrementality

101

Conclusions

102

The transfer pricing of derivatives

103

Introduction

103

The pricing of financial options

104

ix

CONTENTS

Business options

106

Conclusions

107

PART 4: THE STRATEGIC PERSPECTIVE

109

15.

Optimal bank modelling for transfer pricing

111

Introduction

111

Overview of programming model

111

The programming problem applied to a bank situation

113

Interpreting the solution

115

The relationship of the model and transfer prices

116

The impact of constraints

117

The risk relationship of these types of model

118

Conclusions

118

Transfer pricing and management information strategy

119

Introduction

119

The financial and non-financial perspectives

119

Distribution channels

120

Customers

123

Conclusions

125

16.

PART 5: A REVIEW OF KEY ISSUES AND CONCLUSIONS

127

17.

Issues and conclusions

129

Introduction

129

No single transfer price

129

Transfer pricing systems are appropriate for financial institutions

129

Market-based prices and market power

130

Matching

131

Motivation

131

Are transfer pricing systems excessively risk averse?

132

Relating transfer pricing to strategy

133

Conclusions

133

Bibliography

134

Index

145

x

Preface I have always thought that there are three sure signs that a large enterprise is in trouble; they are that an organisation has a great many accountants, is overwhelmed by consultants and in particular has a comprehensive, overwhelming and awe-inspiring system of transfer pricing. Given that I have earned my living in finance, that I am now a consultant and that I propose to write a book on transfer pricing, I am betraying the skills and activities of a lifetime. Things are of course worse in real life. My background is not that of an accountant, I am an economist and this book could not have been written by a person of any background other than that of an economist. This introduction thus exposes all the skeletons in the cupboard. Financial institutions are, however, different in so many ways from other types of large business organisations and it is my view that transfer pricing is an integral part of the sensible management of financial institutions. Although I view it as an important and central feature of sensible management systems my experience tells me that there is much debate and uncertainty as to what constitutes a sensible system for transfer pricing. This book is dedicated to making a contribution to that debate. The book does not provide a recipe for the successful introduction of a transfer pricing system. It is not a consultancy product. The issues are in many cases very intractable and there is, in my opinion, no satisfactory definitive solution to the problems that transfer pricing seeks to address. To take a central issue, how to deal with risk, the theory of finance has tended to define risk in terms of the standard deviation of the distribution of returns of a particular activity. This may be satisfactory in situations where the distribution of returns is normal but in many financial activities returns are not normally distributed. The creation of the concept of value at risk was a practical solution developed within J P Morgan to measure risk in a form which was more meaningful particularly to senior management. This measure of risk has not been accommodated in any comprehensive way into the academic body of theoretical literature on portfolio theory and asset pricing. This means that the establishing of a risk-related element in transfer pricing is not possible in definitive terms since it can derive from a diversity of sources, such as the financial markets, asset-pricing models or diverse

xi

PREFACE

attitudes and definitions of risk. This book seeks to explore the issues and give some indication of how different attitudes and desires lead to different transfer prices. The book, however, does embody the belief that systems of transfer pricing are absolutely necessary to run a financial organisation properly and that transfer pricing in relation to portfolios of financial obligations is necessary and can be very sensible as a guide to an organisation fulfilling its objectives. The problem in relation to many non-financial organisations is that they cannot obtain a reliable vision of the nature of their cost structure and how it changes with different levels of activity. Financial institutions face the same problem in relation to their operating expenses; however, in terms of the inputs of financial obligations into their production process they have an excellent understanding of how their costs vary where the products are bought or sold on financial markets be they wholesale or retail. To provide an example, if an institution raises funds and then invests those funds, the cost structure can easily be estimated, and how it varies can be understood and therefore sensible transfer prices can be generated. There are many individuals who have helped me in developing my insights in relation to this subject. I would like to express my thanks to all of them and a brief list of the most important follows: Sue Millar, Alan Swift, John Haynes, David Withey, Tim Murley, Nick Hand, Ross Geddes, and Z Sevic. I would also specifically like to thank Aslina Mohammed Noor Beg for her help in my research. On a personal note I would like to thank my wife for her assistance. All these people and many more have helped me, but the views contained in this book are mine alone and I absolve my friends and relatives from any responsibility for their content.

xii

Part 1: An introduction to transfer pricing in financial institutions Part 1 gives an introduction to transfer pricing and its uses. The first chapter provides a definition of transfer pricing. In the second chapter there is an outline of the main intellectual traditions from which transfer prices have been understood. These include the economist's perspective that sees transfer pricing as a means of establishing efficient prices within a controlled or planned organisation which replicate those created by efficient markets; it also considers the accountant's perspective that we must use transfer prices that are practical and enable an organisation to be managed in a way congruent with its overall goals and, in particular, its financial goals. The third chapter reviews the application of transfer pricing within business enterprises and uses this perspective to provide a critical context for the generation of transfer prices within a practical context. The final chapter of the introductory section considers transfer pricing for financial organisations from an overall perspective in terms of the uses of transfer prices and their precise applications.

1 What is transfer pricing? INTRODUCTION This chapter outlines the basic general ideas in relation to transfer pricing. In particular, it considers the definition of transfer prices and the reasons why organisations may apply them as part of their management process. It also provides a context in which we will explore transfer pricing issues from the perspective of management of financial institutions in general and not from the perspective of a particular jurisdiction.

THE DEFINITION OF TRANSFER PRICING It is always dangerous to define terms because many definitions have soft edges and may have unintended interpretations. However, we can give the standard view of the role of transfer prices as follows: Where one unit within an organisation supplies another unit with goods or services the payment or receipt made in relation to that supply is a transfer price. There are a number of complications regarding this definition. The term unit within the definition does not necessarily mean a unit of managerial control, i.e. it is not necessarily a department or budgetary unit and there are many other types of unit which may be the subject of transfer prices. There are as many types of unit as there are organisational perspectives and to illustrate some which are not units of managerial control, transfer pricing may be used in relation to projects, products, distributional units, processes and decisions. The definition uses the word `organisation' which is deliberately vague in that it may apply to situations where the transfer price relates to a number of different types of organisational unit. Joint ventures often have costs and revenues transferred between different companies; these would be seen as `single organisational structures' and the transfers between them as transfer prices. The term `payment or receipt' is also rather vague. Whether there is a matching payment or receipt will depend on the way in which the transfer pricing system is

3

TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

established and the payment may not involve any transfer of resources but be entirely notional. It is also quite possible that for a particular supply there may be more than one transfer price because an organisation may wish to produce different transfer prices for different perspectives. In defining a transfer price it is often seen as appropriate to distinguish transfer prices from cost allocation (see Emmanuel and Mehafdi 1994) and, in general, this does not cause a problem in relation to the above definition or to the content of the book. Some considerations in relation to the allocations of operating expenses will be discussed and it will be argued that they form the least satisfactory aspect of any transfer pricing system for the finance industry. Cost allocations and indeed the understanding of operating expenses form the least understood and most intractable problem for transfer pricing.

MOTIVES FOR TRANSFER PRICING There are a number of different types of motivation for the establishing of transfer prices: as a response to the role of government and regulators in the management of organisations; as part of an organisation's participation in relationships with other organisations; as a mechanism to help manage organisations; and as an element in the management of risk. These different motivations, although they can be separated from a conceptual perspective, may not be entirely differentiated in particular instances. To take a simple example, a transfer pricing system designed predominantly for the purpose of enhancing managerial motivation can be used as a basis for determining tax liabilities. In fact, many transfer pricing systems can be established for a series of motivations. It is one of the themes of the book that different motivations for transfer prices give rise to different levels of pricing and a single allpervasive system is unlikely to be satisfactory for all possible usages. A transfer pricing system should be fit for its purpose and any limitations should be recognised and accommodated.

A response to the role of government There are a number of different ways in which internal pricing systems of businesses respond to government regulations; one of the most important is in relation to taxation and the transfer of resources between countries. A pervasive motivation in establishing systems of transfer prices has been to minimise differences in

4

WHAT IS TRANSFER PRICING?

taxes between different tax jurisdictions with the essential ideal being to locate profits in lower tax environments. This can be ensured by making high tax environments pay higher costs and receive lower payments for goods and services with the reverse taking place in low tax environments. There is a problem that given the laws on international taxation care must be taken in establishing any system of transfer pricing since it may have tax implications. The revenue authorities will be uncomfortable if a company does not use its internal pricing systems to estimate its tax liabilities. The moving of financial resources between countries, for example the repatriation of dividends, is still subject to restrictions although these are decreasing due to the operations of international financial institutions such as the World Bank and the International Monetary Fund (IMF). Transfer prices have been used to move resources between countries so that profits can be declared in the desired location. The regulations which govern these types of international transfers are location specific which means that the transfer pricing implications will vary from country to country. The laws and regulatory frameworks established by governments may provide a major motivation for transfer pricing. In establishing sensible prices in regulated industries a knowledge of the cost components and pricing justifications will be required for the regulators and these price justifications may be based on the same principles as are appropriate for transfer pricing. Competition legislation may also require the justification of prices and again the information needed will be identical to that required for transfer pricing. Where law or regulation imposes constraints on the operations of businesses these constraints will have important implications for transfer pricing. In considering the risk management of banking organisations, for example, it is often suggested that exchange and interest rate risk should be concentrated within the treasury function and in certain regulatory environments this is seen as a necessary prerequisite for risk management. For this reason the regulator has specified that a transfer pricing system should operate to ensure that certain types of financial risk are concentrated within the treasury or risk-related function.

Relationships with other organisations A business organisation often participates with other organisations in joint ventures or outsourcing as frequently happens in the financial services industry. The operations of ATM sharing networks and of joint processing facilities are prime examples of this type of agreement. Within these jointly owned operations there are often prices generated for the exchange of goods or services. The use of one bank's Automated Teller Machine (ATM) by another bank's card-holder usually leads to a fee

5

TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

being levied by the first bank on the second bank. These exchanges can be seen to fall broadly within our overall definition of transfer pricing if one considers the joint organisation to be the key one.

Organisational management There are a number of different ways in which transfer prices can be used as part of an organisational management system. In general, they can be summarised as allowing for increased motivation congruent with the organisation's objectives, measuring the impacts of managerial decisions and enabling more efficient decision making. There are a number of different principles of management which underlie the use of transfer prices for enhancing motivation. It is often difficult for management and personnel in smaller units that are part of a large organisation to see their impact on the financial results of the whole. Transfer prices which establish quasi-profit centres will allow units to see their objectives simply and may allow managers to see the actions which they should undertake more clearly. There are few natural profit centres within financial services organisations and establishing sensible profit centres is one of the most difficult tasks: the principles for doing so are one of the major issues dealt with in this book. If profit centres can be established, whether artificial or not, and they correspond to organisational units, then those units can be given greater managerial autonomy. The benefits are more than establishing autonomy; seeing behaviour in terms of profits helps managers envisage themselves as governing independent businesses. These policies may have very strong motivational impacts. Establishing a system of planning, management and control should involve the understanding of how different managerial units contribute to the overall financial achievements of the enterprise. This perspective can be consistent with the issue of enhanced motivation created by transfer pricing. In this way transfer pricing leads to an understanding of how units contribute to overall financial achievement. The understanding of the impact of decisions may require the establishment of transfer prices. To take an example, if a bank wishes to launch a new product and that product involves the lending of money, the decision to launch can only be sensibly evaluated if a transfer cost of funding is established. Any balance sheet-based decision will require the identification of transfer prices for funding.

6

WHAT IS TRANSFER PRICING?

Risk management One key principle of risk management is to ensure that the responsibilities are clearly identified and isolated. Interest rate and exchange rate risk are in many organisations identified and allocated to the treasury function for management and these processes are usually effected through a system of transfer prices. The operating units contain the returns which relate to their activities but their lending and funding are notionally matched and the mismatches are allocated to the risk management function, usually treasury.

THE FOCUS OF THE BOOK This book focuses on those motives for transfer prices which are universal in nature rather than those which depend on the laws and regulations in relation to particular nations or jurisdictions. The impacts of laws and regulations are considered in general terms and this is particularly true in relation to issues raised by taxation and the international transfers of resources. It is not possible to give a general vision of tax or regulations of currency flow because these are country specific and merit a major publication on their own. There are, however, many common themes as regards regulations and these will be considered. In particular, given the universal basis for banking regulations emanating from the Bank for International Settlements, these regulations and their impact on transfer pricing issues will be considered in considerable detail. This book concentrates on transfer pricing issues that are of universal application. To determine what is the appropriate set of transfer prices one must always take into consideration locational impacts which, since they are specific, are not considered within the framework of this book.

7

2 The general theory of transfer pricing

INTRODUCTION There are a number of different methods for generating transfer prices and this section provides a review of the techniques. The key perspectives are derived from economics literature which focuses on the conditions making central planning efficient, and from accounting literature which is concerned with the practical application of transfer pricing within a commercial environment. The next chapter provides an overview of the empirical research on transfer pricing within a commercial background and is drawn from developed `western' capitalist countries.

THE ECONOMIST'S PERCEPTION OF OPTIMAL TRANSFER PRICES The economic theory of transfer pricing was initially developed to understand how optimal planning might take place in a socialist economy. Over the years it has become the basis for developing transfer pricing systems within enterprises in capitalist economies. There is a wide range of papers in this tradition of which Lange (1936±7), Hirschleifer (1956, 1957, 1964) and Gould (1964) are the most influential. The model outlined in this section seeks to explore the main theoretical insights of the economics literature in relation to transfer pricing. It considers a firm with two departments: a basic production department and a finishing and sales department. The production department manufactures the output which it can sell to an outside market or provide to the sales department. The sales department can buy the product from other suppliers and sell the final output on the market. This situation can be set up as a standard maximisation problem and, since it is an economic model,

8

THE GENERAL THEORY OF TRANSFER PRICING

shareholder and economic value are maximised. One can compare the situation where both departments are run as a single profit-maximising unit with that where both departments are run separately and the production department has a choice of selling the product direct to the market or to the selling department for a transfer price. The model identifies the transfer price which will lead both departments to maximise their joint profit. If the transfer price does not equal that price then the departments will behave in a way which produces less profit for the whole organisation and decision-making will be dysfunctional. In the initial model of the firm, both the production and sales department are managed in conjunction and a joint profit maximisation decision is established in terms of the levels of sales by the production department to the market, the level of purchases of the product from the market and the level of sales by the sales department. Since the model assumes that the firm has market power in all the markets in which it trades, the setting of sales and outputs can be see as one solution which implies a set of prices in each of the markets in which it trades. If the appropriate set of prices was established then the sales would be at the optimal levels. It is the standard idea that the firm with market power can either set prices or the quantity of trades. If the firm were a price taker in any market then the revenue function would just be the market price times the quantity of sales and the result would be a special case of the general model, the marginal revenue being the price. Considering the general model, equation 2.1 is a profit function for the firm. This model is set up for a single time period but this type of model can be established for a number of time periods. In general, however, the results will take the same form if there are no links between performance in the different time periods. The firm has two revenue functions Rs(q2 + q3) and Rp(q1), the first being for the final product sold by the sales department and the second for the intermediate product sold by the production department outside the firm. The firm's cost function is broken up into three components Cs(q2 + q3) which is the cost of finishing and sales, Css(q3) which is the cost of the sales department purchasing the intermediate goods and Cp(q1 + q2) which constitutes the costs of the production department. The form of Css(q3) indicates that the firm has market power in this market and is not faced by parametric prices.

9

TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

Joint profit maximisation P

= Rs(q2 + q3) + Rp(q1) ± Cs(q2 + q3) + Cp(q1 + q2) ± Css(q3)

[2.1]

P

= Profit of the joint business

q1

= The amount of output of the production department sold outside the firm

q2

= The amount of output of the production department sold inside the firm

q3

= The amount of output bought outside the firm by the sales department

Rs( )

= The revenue function of the sales department

Rp( )

= The revenue function of the production department

Cs( )

= The cost function of the sales department

where:

Css( ) = The cost function for purchases by the sales department outside the firm Cp( )

= The cost function of the production department

The joint first order profit maximising conditions for the firm are: dP dq1 dP dq2 dP dq3

= = =

dRp dq1 dRs dq2 dRs dq3

± ± ±

dCp dq1 dCs dq2 dCs dq3

[2.2]

=0 ± ±

dCp dq2 dCss dq3

=0 =0

[2.3] [2.4]

The optimal levels for the choice variables q1, q2 and q3 satisfy these conditions as is implied. The conditions are all variants of the normal marginal revenue which equals marginal cost conditions. There are other sets of conditions implied by the functional form of the equations contained in the model. They are outlined in equations 2.5 to 2.7. dRs dq2 dCs dq2 dCp dq1

10

= = =

dRs

[2.5]

dq3 dCs

[2.6]

dq3 dCp dq2

[2.7]

THE GENERAL THEORY OF TRANSFER PRICING

The meaning of these marginal conditions will be outlined. Equation 2.2 suggests that the marginal revenue from outside sales equals the marginal costs of production. Equation 2.3 suggests that the marginal cost in production added to the marginal costs in the sales department should equal the marginal revenue in sales. The marginal revenue in sales should also be equal to the sum of the marginal costs in sales and the marginal cost of buying in the product from the outside market as is indicated by equation 2.4. The marginal costs in the production department for the outside and inside sales should be the same as indicated by equation 2.7. Equation 2.6 suggests that the marginal costs in relation to the selling department should be the same for the product bought in as for the product manufactured by the production department and equation 2.5 indicates that the marginal revenues for the internally produced and bought in should be the same for the sales department. We have not outlined the second order conditions for maximisation since they add little to the explanatory content of the model. The required mathematical conditions can be assumed to apply. The initial model considers a firm which is managed as a single unit and as a single profit centre where decisions are made centrally. This model outlines the maximisation conditions which the firm must satisfy in its operations.

Profit maximising conditions for production department We can now go on to consider the firm as composed of two separate units with separate managements who make their own decisions. The units q2 which are transferred from the production to the sales department do so at a transfer price of Tp. In these circumstances the profit maximising models for the individual departments are as follows: Pp = Rp(q1) + Tp(q2) ± Cp(q1 + q2)

[2.8]

The first order maximisation conditions are: dPp dq1 dPp dq2 dCp dq1

=

dRp dq1

= Tp =

dCp

± ±

dCp dq1 dCp dq2

= 0 = 0

[2.9]

[2.10] [2.11]

dq2

11

TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

These conditions are those of profit maximisation for the production department and again are standard marginal cost and revenue conditions.

Profit maximising conditions for sales department The conditions for the sales department are as follows: Ps = Rs(q2 + q3) ± Cs(q2 +q3) ± Css(q3) ± Tp(q2)

[2.12]

The first order conditions for profit maximisation are as follows: dPs dq2 dPs dq3 dRs dq2 dCs dq2

= =

dCs dRs ± Tp = 0 ± dq2 dq2

[2.13]

dRs

[2.14]

dq3

±

dCs dq3

±

dCss dq3

=0

=

dRs dq3

[2.15]

=

dCs dq3

[2.16]

If one considers the profit maximisation conditions for the two as separate entities with the joint profit maximisation solution equations, they are the same except for the equations in which Tp occurs. Therefore, if there are to be any problems in the separate management of the two departments they will be related to making equations 2.10 and 2.13 consistent with equation 2.3. The degree of consistency depends on at what level the transfer price is set. If one sets it so that the maximising conditions are satisfied in the two departments and jointly for both combined, there is a single transfer price which is both the receipt of the production department and the expenditure of the sales department which we can obtain from equations 2.10 and 2.13.

Optimal transfer prices Tp =

12

dCs dCp dRs = ± dq2 dq2 dq2

[2.17]

THE GENERAL THEORY OF TRANSFER PRICING

The optimal transfer price is thus the one where the marginal costs of the production department are equal to the difference between the marginal revenue of the sales department minus the marginal costs of the sales and marketing department on selling the output of the production department.

COMMENTS ON THE SIMPLE OPTIMAL PRICING MODEL This style of pricing model provides some very important conclusions which are, in general, radically different to those of much transfer pricing practice. This section seeks to outline the most important issues in the area and to provide some introduction to the problems encountered.

Outside prices An outside market price, if there is one for the goods or services which are to be the subject of the transfer price, is often used as a transfer price. It represents the opportunity cost for the department purchasing the goods or services, since they could purchase them in the market at that price. It represents an objective test which, if the supplying department matches it, is as productive as the outside competition and if it is not competitive, is a poor use of resources to supply internally. The important issue revealed by the simple transfer pricing model is that this will only be an appropriate transfer price if the firm using the system is not a price maker in the market for the product. If it is a price maker the marginal conditions will be such that the transfer price should not necessarily be equal to the current outside market price.

Fixed costs As with all maximisation problems the solutions depend on marginal conditions: fixed costs are ignored but this insight has been greeted by practical business people with a great degree of cynicism. To be accurate, the economist would generally add a caveat that fixed costs should be used to decide if the activity should be undertaken at all and if it is worthwhile to undertake the activity then the marginal conditions should be used to determine the optimal solution.

13

TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

Partial information The maximising model assumes that we can identify the Cost and Revenue functions and that we can easily undertake optimising these functions but this is certainly not obvious in any practical situation. In general, firms have focused on their cost structure or on outside market prices in establishing transfer prices and have not considered marginal revenue functions. In considering their cost functions they have found two areas to be significant: the attribution of costs to products and the distinction between fixed and variable costs. The developments in relation to activity-based costing have improved our understanding of the relationship between costs and products. However, the results of activity-based costing have been more problematic in determining the relationship between fixed and variable costs: it makes sense to see them as the ends of a continuum with many costs being neither entirely fixed nor entirely variable. Often costs can vary potentially but require the intervention of management to relate costs to volumes. One aspect of activity-based management is that it can increase the variability of costs but there will always be some uncertainty as to the precise nature of particular costs. There is a further set of issues regarding the costs included in economic models and how they differ from accounting costs. In this context opportunity cost and the cost of capital must be discussed. Costs in economics are opportunity costs and they reflect the alternative uses of resources: accounting costs do not necessarily do so. The economic models also include in costs a charge for any capital bound up in a project and a required return on that equal to that which could be obtained on the capital market. There are many difficulties bound up with capital charges and they will form a major issue dealt with in Chapter 10. The recent developments in the use of the concept of economic value has made many firms focus on this issue of capital costs. However, the ambiguities associated with costs are one of the major practical problems associated with establishing any system based on optimal transfer prices. One issue often quoted as a reason for not having optimal transfer prices is the following: an organisational unit which is established as a profit centre will make losses as a result of a marginal based transfer pricing system and this therefore will remove motivation from the organisational unit. Whether or not this is a sensible psychological argument is open to debate, but the difficulty can easily be eliminated. If two transfer prices are established, one relating to marginal transfers and another to a fixed payment per time period, then the optimal transfer price which is established for the variable transfers will be consistent with profit centres making maximum joint profits.

14

THE GENERAL THEORY OF TRANSFER PRICING

TRANSFER PRICING: THE ACCOUNTANT'S PERSPECTIVE Accountants have tended to have a more eclectic approach to transfer pricing. They have certainly considered and used transfer prices which are optimal from the economist's perspective, but they have in general been more practical in their own views and related more to what has been used for transfer prices within the commercial world. What follows is a review of the different methods which are commonly referred to in the accounting literature and the techniques have been well summarised by Kaplan and Atkinson (1989).

Marginal cost The marginal cost of producing goods or services is the addition to costs which results from the provision of one extra unit. If the transfer price is set on this basis it prevents certain dysfunctional behaviours by the different organisational units. If the transfer price is set above the marginal cost then the supplying department has an incentive to sell as much as possible since it will make an extra notional profit on each unit sold. If the transfer price is set below the marginal cost then there is no incentive for the supplying department to provide an extra unit. Where the supplying department has the option of selling on the open market external to the firm and the purchasing department can buy on that external market there will be pressures to force the transfer price towards a sensible marginal value. However, if there is no possible source of external supply a non-marginal transfer price may cause problems. Marginal cost transfer prices are often accompanied by fixed value payments between departments during each accounting period. The arguments for this are to some extent adjusted to the psychological impacts of making a loss on a supplying department as discussed above. The marginal cost-based transfer price may imply that the department will make a loss since it will not be able to cover its fixed costs or the marginal costs of intra-marginal units. A fixed payment can ensure that the unit makes a profit.

Variable cost Accountants, notably Kaplan and Atkinson, distinguish between marginal cost transfer pricing and variable cost transfer pricing. In essence, the distinction stems from the difficulty in practical situations of differentiating costs between those that are fixed and those that are variable. Many costs do not easily fall into either of these two categories: they may be fixed in the short-term and more

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TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

variable over longer decision periods. Some costs vary in relation to volumes only if they are the subject of managerial decision-making. Staff costs, for example, may often only vary with volume if there is a specific managerial decision to recruit or to lose staff. This issue is discussed in more detail in the sections on transfer prices for operating expenses in Chapter 7. The variable cost-based transfer price is therefore based on a wider definition of marginal costs and includes costs that are less clearly variable. The variable cost transfer price can be either the equivalent of a wider-based marginal transfer price or an average-based transfer price. The advantages of marginal-based prices are demonstrated in the mathematical model considered above. Average-based transfer prices are only optimal if the average and the marginal are synonymous and average-based transfer prices can lead to erroneous decisions. Smullen (1995a) Average costs within this category of transfer pricing are only those that are considered to be variable.

Full cost or average cost Full cost transfer pricing involves the allocation of all costs to whatever cost objective is being considered. The full cost is then divided by the number of units to derive a price per unit which is used as the transfer price. This technique will involve some arbitrary allocations of costs. The distinction between this technique and a variable-based cost approach, insofar as costs are allocated by an activity-based costing system, will be that some fixed costs can be related to a particular cost objective. An example of a fixed but related cost would be the marketing expenditure related to a product. Marketing expenditure on any definition will almost certainly be fixed. The full cost or average cost transfer pricing mechanism is just another version of an average cost transfer price and will not produce optimal results. Often these transfer prices include all allocated overheads. Although transfer prices based on fully allocated costs have apparently little theoretical foundation, they are used widely in practice. Miller and Buckman (1987) and Tomkins (1990) argue that in practice these tools provide a good approximation for more optimal pricing techniques.

Cost plus mark-up This type of transfer price is an average cost plus a mark-up to allow the selling unit to make a profit and will not lead to optimal performance. The additional problem with this technique lies in providing a sensible level for the mark-up: because of its nature it will not have a rational economic justification.

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THE GENERAL THEORY OF TRANSFER PRICING

Negotiated Transfer prices can be negotiated within an organisation. If they have an impact on organisational performance, or influence the evaluated performance of management they will be a strong impetus for managerial attention. Where they are the subject of managerial politics they can lead to dysfunctional prices and dysfunctional decision-making on the basis of those prices. Negotiated prices do not necessarily have a sensible relationship with optimal transfer prices.

CONCLUSIONS The simple pricing model we have used to understand the value of the different types of transfer price is an optimal transfer pricing model. It is the contention of this book that financial institutions can improve their performance if they build optimal transfer pricing models which are less likely to lead to dysfunctional results, although there are many practical issues involved in building such models that must be considered. A financial institution, because of the nature of its financial assets, liabilities, inputs and outputs, can more easily and meaningfully exploit systems of optimal pricing than can other types of business enterprises. Accountants are more pragmatic in relation to transfer prices than are economists: they are also closer to general business practice. The core issue in establishing transfer prices relates to the ability to understand the cost and revenue structure of an enterprise in a sensitive manner. The economists have not considered how the cost structure can be understood and measured while the accountants have tried to deal with this intractable problem. The core of commercial issues lies in this area. When we consider financial products and relationships we will see that this problem is less important given the nature of the cost structure for financial organisations because there is an outside market which will provide extensive assistance in establishing transfer prices. The inputs of financial organisations come from wholesale and retail financial markets.

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3 Transfer pricing in commercial organisations INTRODUCTION Emmanuel and Mehafdi (1994) provide a survey of transfer pricing theory and practice. In it they summarise the findings which cover the period between the 1970s and 1990s in relation to the different types of transfer pricing used in different countries as revealed by academic studies. Most of the data are based on postal surveys and therefore must be considered indicative rather than entirely accurate. However, since the data is being used to illustrate the diversity of transfer pricing practices in operation any issues in relation to measurement error are not of central importance. The findings are summarised in Table 3.1 and Table 3.2. The entries in the tables refer to the percentages of firms using a particular transfer pricing technique. If, for an individual country, there is more than one study used (see footnotes to Tables 3.1 and 3.2) then the maximum value of a particular category has been entered in the relevant table. In addition, an individual enterprise might use more than one technique and so the columns may add up to more than 100%; where the columns total less than 100% not all the firms sampled had transfer prices.

Table 3.1 Single country transfer pricing systems UK Basis Variable cost Full cost Market based Negotiated Total

20 57 70 42 189

USA 9 78 55 32 174

Germany 8 33 46 0 87

Japan 3 57 54 31 145

Canada

Australia

France

8 41 50 28 127

10 42 54 11 117

21 49 9 12 91

Sources: Rook (1971), MBS (1972), Tomkins (1973), Emmanuel (1977), Tang (1981), Mostafa (1982), Mehafdi (1990) (UK); Vancil (1978), Tang (1979), Tang (1992) (USA); Drumm (1972) (Germany); Tang (1979) (Japan); Tang (1981) (Canada); Chenhall (1979) (Australia); Bafcop et al. (1991) (France)

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Table 3.2 Transfer pricing in multinational context

Basis Variable cost Full cost Market based Negotiated Total

UK

USA

Japan

4 33 38 30 105

4 66 67 25 162

3 33 31 19 86

Canada 4 17 25 17 63

Sources: Tang (1981), Mostafa (1983) (UK); Wu and Sharpe (1978), Tang (1979), Tang (1993) (USA); Tang (1979) (Japan); Tang (1982) (Canada)

SINGLE COUNTRY TRANSFER PRICING SYSTEMS The data in Table 3.1 indicate that three methods of transfer pricing are widely used in the domestic firms throughout the developed world; these three are full cost-based, market-based and negotiated. Because these transfer prices are used within a single country they are termed domestic. Variable cost-based transfer pricing does not appear to be widely used, possibly because isolating and understanding variable costs is not easy within most costing systems, even within those based on the more modern methodologies, for example activity-based costing.

MULTINATIONAL TRANSFER PRICING PRACTICES The data in Table 3.2 refer to multinational transfer pricing practices as opposed to domestic practices detailed in Table 3.1. The picture, however, in the two data sets is very similar which indicates that variable cost transfer pricing is not widely used within the business community.

COMMENTS ON TRANSFER PRICING EXPERIENCE The relationship between the commonly used bases for transfer pricing and that for optimal transfer pricing is ambiguous: as Emmanuel and Mehafdi (1994) point out the strategic motivation for transfer pricing is not well understood within the academic community. There does, however, appear to be some value in outside-based transfer prices from an economic perspective in situations where the firm does not have market power and this point is discussed more fully in Chapter 2 in the section on the economic perspective to transfer pricing in this chapter. Negotiated prices may reflect market

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prices in certain conditions. There is also some academic support for full cost-based transfer prices as a proxy for optimal prices where an enterprise does not have sufficient information to calculate optimal transfer prices. (Zimmerman 1979, Millar and Buckman 1987; Tomkins 1990) One is, however, struck by the contrast between the economist's view of transfer pricing and the sources of transfer price used within business. It appears that the reservations with the economist's viewpoint relate to the practical quantification of the factors which the economist finds important. The techniques which are used, it is argued by some academics, are proxies for the economist's significant variables. It is difficult, in my experience, to convince managers of the validity of a marginal approach to transfer pricing and the prevalence of the other techniques is, I suspect, in part an issue of managerial understanding. The data on transfer pricing revealed in the above surveys do not consider what is happening in the finance industry generally and should be seen as a typical perspective on the business community. They do indicate, however, that attitudes to transfer pricing within the business community are far from clear cut, and that transfer pricing is a complicated issue that should always be approached with caution.

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4 The uses of transfer pricing in financial organisations

INTRODUCTION This chapter gives an overview of transfer pricing for financial institutions. It attempts to consider why financial institutions establish systems of transfer prices, what is transfer priced in actual practice and what are the different categories of transfer prices.

THE NATURE OF TRANSFER PRICES There are many different purposes for which transfer prices are used in financial institutions and, indeed, many different types and levels of price that can be generated. It is important always to be aware of this issue since it is easy to use the wrong set of prices for a particular purpose and the use of an inappropriate transfer price may lead to poor decisions. In a financial institution, for example, any business plan may involve a valuation of the gains from an investment in terms of financial products sold or purchased. If a particular decision requires a small additional funding for the organisation it may be obtained at a particular price, if the funding required is not marginal then the price faced by the organisation may be entirely different. It is important to ensure that the appropriate price is used in each situation. The transfer price in these situations may be decision- or use-specific.

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Government based motivations management

Relationship with other organisations

Organisational management

Risk management

Ensuring sensible response to regulation

Pricing for services

Strategy formulation

Isolating risk

Requirement for competition regulations

Decisions on outsourcing

Establishing financial impact of entity

Motivation of risk management

Evaluation of M&A

Motivation Pricing

Benchmarking

Decision evaluation Planning and budgeting

Figure 4.1 The main uses for transfer pricing in financial institutions.

USES OF TRANSFER PRICING The key focus of this book consists of transfer pricing issues of universal application which means that issues such as those related to tax minimisation are not considered. The main perspectives for transfer pricing are illustrated in Fig. 4.1. They are analysed in terms of the categories outlined as the motivations for transfer pricing in Chapter 1.

Government-based motivations The actions of government may have an impact on the transfer pricing system of a financial institution in a number of different ways of which the most central relate to capital and liquidity requirements. Capital is used in two ways: it can be a buffer against default to protect providers of funds with the exception of equity and certain debt holders (depending on the classifications considered as capital) and can also be an element of funding. It is allocated as a buffer against the default of a certain type of business and as a funding source. These issues are discussed at length in Chapter 10 where many of the systems of established capital allocation are criticised. Liquidity regulations may also have an impact on transfer prices in that certain assets need to be held to guarantee solvency against the liquidation of short term obligations. Both capital and liquidity regulations may also be constraints for an organisation. These issues are dealt with in more detail in later chapters.

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THE USES OF TRANSFER PRICING IN FINANCIAL ORGANISATIONS

When responding to competition authorities, it is often necessary to identify and establish the cost structure for services: this can only be established for many financial products by the consideration of transfer prices and in this way demonstrate the exact nature of the costs and revenues for a particular activity.

Relations with other organisations Joint venture is a common form of activity in the finance industry and perhaps the most obvious example of this is in relation to ATM sharing networks. In these networks customers from any member organisation can use another institutional member's ATM. The charging systems for these arrangements take two forms: charges by institutions on their customers and charges by the service provider to the organisation whose cardholder uses the ATM. The setting of customer charges by either the host or cardholder's bank is a general matter of price setting which may or may not be associated with the institution's cost structure. The charges levied by one institution on another, however, tend to be cost-based and almost certainly defined on the basis of operating expenses. The specification of costs to be included will be the result of very careful and specific negotiation. Some fixed costs, for example, may be allocated to transactions on the basis of a certain level of agreed volume. The nature of transfer prices will probably be decided on the basis of negotiation within the framework of the overall association. The decision to outsource will in many cases also be motivated by an understanding of the operating expenses cost structure and must be viable in terms of lower costs and a requisite level of quality. The fact that services can be delivered with economies of scale and the advantages of a particular processing focus can lead to benefits. For the transaction to prove worthwhile to the two parties then transfer pricing needs to be established on both sides. Again, the evaluation of any mergers and acquisitions (M&A) proposal in the finance industry will require valuation and evaluation of the financial impacts of the decision. If, for example, one wishes to acquire a mortgage portfolio then it will be necessary to evaluate the funding as well as the expected interest rate payments on the mortgages and the funding evaluation will be based on what is considered to be the sensible transfer price. The setting up of benchmarking agreements between financial businesses has increased over the past few years. In general, they are set up by consultancy companies that specify the exact nature of the

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TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

costs and the quality measures to be reported. The results are then presented in such a way that the parties cannot identify the data from particular individual organisations. The relationship between unit cost and quality is a common outcome with these systems. It is not surprising that low cost providers often have a poorer quality performance and this is often due to the fact that the more volume processed, the lower the overheads per unit, the closer to capacity of the system and the lower the quality.

Organisational management The most central use of transfer pricing within a financial institution is as an aid to the management of the organisation. This is seen in terms of understanding how a financial organisation generates value and the setting up of the management and motivational systems that allow it to achieve a desired level of performance. In developing organisational strategy it is important to develop financial models which enable the organisation to foresee the financial impacts of different versions of management planning. One key use of transfer pricing is to allow the breaking up of the organisation into units and activities so that it can explore what these contribute to organisational value and it is also important in understanding how value is generated within the organisation both to stimulate policy and to set up motivational systems for individuals and groups of employees. The most important perspectives for the units in question are those of profitability, economic value and present value. While profitability has been the traditional perspective in the evaluation of individual sub-units in recent years, the concept of shareholder value has become a more important motivation for public companies including financial organisations. It impacts more directly on the most important group of stakeholders who are the shareholders or owners. It is difficult to relate internal behaviour and policy to gains for shareholders. In essence, there are two financial techniques which have been employed to generate shareholder value; each is a version of economic value or present value. In essence, economic value looks at the cashflows of a unit and deducts from them a capital charge for the capital they use in their operations. However, the allocation of capital is a contentious issue. Capital can take a number of perspectives in a financial organisation and its allocation is a matter of some controversy. It can be seen as a source (or part of a source) of funding and should require a return commensurate with the risk involved in an activity. It can also be seen in terms of a regulatory

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THE USES OF TRANSFER PRICING IN FINANCIAL ORGANISATIONS

requirement and allocated on the basis of the regulatory capital required in a particular activity. Capital can also act as a buffer against exceptional losses and be allocated on the basis of a system of relating risk to activities, the most frequent of which is a value at risk method. The issues on capital allocation are complicated and will be debated extensively in later chapters. Suffice to say that the measurement of economic value requires a capital allocation and the nature of that allocation is far from easy to determine. Economic value is a method of evaluating the current contribution of organisational units to the creation of shareholder value and so the setting up of economic value centres is an important mechanism for understanding the value of individual activities. Present value is a method of understanding the future as well as the present contribution of an activity to shareholder value and present value calculations will require an allocation of capital and a transfer price for capital. It is probable that managing for shareholder value will include the two methods of economic value and present value. Breaking down an organisation's activities into different sub-units and producing financial statements for those sub-units can be done in a variety of ways. The precise choice should be dependent on the method by which an organisation manages itself and in the implementation of its strategy. The choices available are summarised in Fig. 4.2. Not all institutions will wish to produce a financial perspective for every type of unit. The actual format of potentially variable information is also very dependent on the nature of each individual unit or activity and how each fits within the strategy and management of the organisation. The list of categories presented in Fig. 4.2 is meant to be comprehensive but there may be issues regarding the appropriate information in each of the categories listed. It is important to realise that the appropriate context for each unit may depend on the way in which it fits within the strategy of the organisation and to the combination of financial and non-financial information for that unit, which must also be considered.

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TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

Strategic business units Budgetary centres Business units

Present value

Distribution channels

Economic value

Individuals and groups

Profit and loss

Products

Balance sheet

Customers

Cash flow

Processes Activity Decision Projects

Figure 4.2 Possible categories for splitting up an organisation with a transfer pricing system.

Categories of financial information The focus on shareholder value has made individual institutions concentrate on the elements within their businesses, either in terms of economic value or of present value. Either calculation will probably require the establishment of transfer prices if the relative impact of a given activity on the business is to be evaluated. The measures which relate to the creation of shareholder value are generally for internal usage but they can be estimated by those outside the company: for example, Stern Stewart have used their concept of EVA1 to produce external measures of corporates which in recent years have been widened to include the banking sector. The use of transfer prices to evaluate balance sheets, profit and loss statements and cashflow statements is related to using transfer prices to establish metrics for individual activities. These help determine how the activity contributes to the value and financial accounts of the business.

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THE USES OF TRANSFER PRICING IN FINANCIAL ORGANISATIONS

Categories of activity The activity categories are the different perspectives from which a business adds value. If it is possible to break up the business into its components and to establish sensible transfer prices then one can understand the impact of individual units in the generation of financial returns. To do this sensibly is one of the most important and difficult problems in relation to transfer pricing and relating financial information to strategy and rational behaviour is far from easy. These issues are considered in the final part of the book where it is concluded that the correct information may prove to be organisation- and activity-specific. There is no simple formula which can be used to generate appropriate information, financial or otherwise, for any organisation. Business units and strategic business units tend to be specific to any one organisation and a difficulty in their analysis is to ensure that they are judged in a way which is congruent with the total interests of the total business group. These units may have independent managers who can pursue their own self-interest in a way which contravenes the culture and practice of the group leading to a distinct possibility of dysfunctional behaviour if sensible transfer prices are not generated. The transfer prices are indicative of the relationships between the group and the business unit and they will be subject to considerable scrutiny from the business units' management. Many budgetary units within a large organisation are likely to be cost centres rather than revenue or investment centres. In order to turn these into profit- or value-related organisational units or to analyse the unit in order to understand how they contribute to the value of the business, transfer prices will be required. If the unit becomes independent it is important that the prices do not lead to dysfunctional decision-making. The key problems in this respect relate to the strategic role of the unit and the extent to which that role can be measured within a financial perspective. In Chapter 16 a case study is presented. It describes the retail branches of a bank and illustrates how complicated it is to find the appropriate financial and management perspective in which to embed transfer prices. To these strategic issues must be added the extent to which prices are based on operating expenses since these costs are the least easy to understand and thus may not provide an acceptable basis for transfer prices. Individuals and groups (such as sales staff and dealing staff within the treasury function) can form important units within organisations and their performance monitoring may be based on transfer prices. Products are key profit generators in any financial services organisation and an understanding of how they contribute to profitability provides basic organisational insights. Product analysis and how products generate value may be the basis for organisational accountability or form a fundamental

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TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

framework for the development and understanding of marketing policy in which it is important to determine whether a particular product generates an appropriate return in relation to risk. The definition of an adequate risk return is one of the most vital questions addressed by the transfer pricing system of any financial institution. Processes and activities are vital in delivering value within any organisation. It may be possible to establish some estimate of the value generated by these facets of an organisation's behaviour but it is, in general, most difficult to use these to generate sensible transfer prices. Projects in well-managed organisations are subject to an elaborate planning discipline which is accompanied by the development of a business plan. The financial perspective is likely to require the development of transfer prices since there are likely to be the following: implications for the balance sheet in terms of financial products; charges and discounting based on capital charges and the possibility of involving options and option pricing. If decisions are important to an organisation they should be the subject of similar scrutiny. To summarise, there are issues as to what may be the correct information in relation to each organisational unit and how sensible financial and non-financial information dovetail. The correct or sensible solution for one type of organisation or unit is unlikely to be universally applicable. In other words, although transfer pricing issues are important they are not the only ones which can be used in producing the correct information. The use of transfer pricing systems to establish profit centres and investment centres for different types of unit may lead to behaviour which is more consistent with the overall goals of the organisation and enhance the motivation of staff. I have often heard it argued that branch managers will be more motivated if they see that their branch is a profit centre and transfer pricing is an essential tool to establish such centres. In most cases, the important issue is whether or not it is possible to set up profit and investment centres whose motivations are congruent with the objectives and strategy of the business and, usually, the more isolated the unit the more likely it is that such centres can be established. However, it is easily seen that the profitability systems will not necessarily reflect the strategic views of how branches should operate and enhanced motivation may lead to counterproductive behaviour. Transfer pricing systems may be used to establish profit centres but this must be done with caution since the financial picture must reflect all attitudes the organisation wishes to instil in its workers.

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THE USES OF TRANSFER PRICING IN FINANCIAL ORGANISATIONS

Pricing is another central issue which can involve transfer pricing systems. In essence, one can distinguish two basic markets in which financial products are sold: those in which the market sets the price and the individual institution has no influence on the level of price set and those in which the business is a price maker and decides on the levels of pricing. In essence, transfer prices establish the cost structure in terms of the expenditure involved in supplying the product and any risk premium which needs to be obtained in that type of business. Cost-based information for pricing has two roles. In markets where the price is set such information allows an institution to decide whether it can obtain the required return from that market. The transfer price-based information helps managers decide whether an institution should be a supplier to a particular market or not. Where the institution has market power the transfer price will determine what are the minimum levels of return to be obtained in the pricing. If those levels are not established the organisation should not supply the product but if it can make a return which covers any risk adjusted return requirements that will establish the minimum. The price which is set should then relate to what the market will bear. In markets where a business has market power cost-based prices are not sensible and market forces should be considered in detail. The above discussion on pricing is somewhat simplistic and pricing issues will be considered elsewhere in this book. In addition, there are many issues involving crosssubsidisation in the financial services industry which must be borne in mind. Finance in any organisation has a central role in ensuring that decisions have a sensible financial basis. Almost all such decisions require one or more of the following: the valuation of funds, the valuation of embedded options and understanding a required return on the business. This means that transfer pricing systems are vital to the making of any major decisions. The use of transfer pricing as part of the planning and budgetary process is linked with motivation. If the budgetary and planning units are set up to establish profit or investment centres then they will often require the use of transfer prices. If an organisation wishes to establish a system on the basis of economic value then it needs to allocate capital to individual units. Thus in establishing revenues and costs it is essential for any budgetary and planning system which wishes to establish profits or investment centres to be subject to transfer prices.

Risk management Risk management is increasingly a vital activity for all financial organisations. The most common classification of risk in the financial community divides it into market, credit and operational risks.

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Market risks relate to the movements in financial market variables such as exchange rates, interest rates, asset and commodity prices. Credit risks are those in relation to whether counterparties to an agreement fulfil their obligations. Operational risks are unusually classified as those that do not belong to either of the two other categories and they tend to take the form of a list. They include process problems, legal risks, reputational risks and fraud. The list in relation to operational risk for any given business can be endless. The different types of risk are usually separated from the perspective of risk management with market risks concentrated in a central risk management function. Credit risks and operational risks may be centralised but this is more a matter of judgement for organisations; their centralisation is not usually a matter for transfer pricing. The market risk amendment emanating from the Bank for International Settlements has led many banks to concentrate their market risk in a particular organisational unit for its management as detailed by Chorafas (1997). This is done by a set of transfer prices in relation to funding. A unit which raises funds of a particular currency and term will receive revenues matched from the centralised unit; a unit which lends in a particular currency for a particular term will pay for the funding of that currency and term to the centralised unit. The concentration of any interest rate or currency mismatch is thus in a centralised risk management unit. If risk is centralised it can be managed more efficiently since there is a dedicated responsibility for risk management of this particular type. The concentration of risk also allows the benefits of any offsetting to be realised clearly and simply. If the risk management is associated with the treasury function then the function can be evaluated on the clear basis of performance.

DIFFERENT TYPES OF TRANSFER PRICE There are different types of variable which might be transfer priced in a financial organisation. Each is intrinsically different and therefore each requires a different pricing technique. Each one is considered separately in the following discussion.

Operating expenses There are many instances within a financial organisation where there is a need to establish transfer prices for services which depend on the understanding of how the operating cost structure behaves.

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THE USES OF TRANSFER PRICING IN FINANCIAL ORGANISATIONS

These transfer prices involve considerations which are in many ways the same as those involved in any other type of commercial organisation. Limitations about the understanding of cost behaviour apply to transfer prices of this type and they are likely to be the least satisfactory when they refer to financial institutions.

Funds The transfer price of funds is of vital concern to financial organisations since one of their most important functions is to raise funds and lend them. Most financial organisations are in essence financial intermediaries. The transfer price for funds is usually seen in terms of replicating the prices found in financial markets but there are a number of issues as to whether wholesale and retail funds should be treated in the same manner which will duly be considered.

Portfolio returns In the evaluation of the performance of any portfolio of investments it is necessary to ensure that an adequate understanding of risk-adjusted returns is established. In many ways these types of transfer price are analogous to funds transfer prices but they derive from an understanding of risk-adjusted returns in relation to portfolio management.

Capital The advent of shareholder value maximisation combined with the developments in relation to measuring risk by Value at Risk and the increasing focus on capital regulations have led many organisations to allocate capital to their various activities. The identification of what capital should be allocated to a particular activity and what price should be charged for that capital are important transfer pricing issues.

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Derivatives An important set of inputs and outputs for financial organisations is derivative products which can be valued by a number of standard techniques. Increasingly, there is an understanding that financial products contain derivatives and there has, in recent years, been an increasing understanding of the nature of embedded options in financial products. Perhaps the area which has received least attention within the industry is that of the role of real options and their pricing. Many strategic investments are investments in real options which need to be adequately priced, and this means that any sensible financial organisation needs to understand how these financial obligations are valued.

CONCLUSIONS Transfer prices have many and diverse purposes. Not all uses of transfer prices are identical and indeed some transfer prices may not even be part of a system for general transfer pricing. For instance, a strategic decision which involves a major shift in funding may change the interest rate structure faced by the organisation and require unique decision-specific transfer prices. An organisation may embed transfer prices in many different information and motivational systems and there are many units which require other strategic performance measures in addition to finance-based systems. For these reasons the application of transfer prices within financial organisations requires sense and subtlety in determining what prices are appropriate. Sensitivity is required to determine the exact informational vehicle in which transfer prices should be embedded.

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Part 2: Setting transfer prices in financial institutions In this section of the book the author deals with some of the important topics which must be considered when establishing sensible transfer prices. In Chapter 5 he reflects on some overview issues about how transfer pricing systems may fit within an overall organisational perspective, firstly discussing the relationship between financial systems and the strategic perspective and secondly showing how organisational units fit together. In Chapter 6 there is an introduction to the perspective of risk which is central to any sensible understanding of the returns required by a financial organisation.

5 Integrating transfer prices with organisational structure

INTRODUCTION One of the most difficult tasks for finance officers in contemplating their role within a business is how to relate financial and non-financial management issues. It is important that any financial management system does not create dysfunctional behaviour due to its inconsistency with other aspects of management. In this chapter the author considers how one can ensure that uniformity between financial and non-financial information is maintained and the ways in which transfer pricing systems may deal adequately with the interrelationships of organisational units.

FINANCIAL INFORMATION: THE STRATEGIC PERSPECTIVE As has already been observed, recent years have seen an increased focus on shareholder interests. In the USA and UK shareholders have moved from being one among many stakeholders to become the central interest which the business should accommodate and this trend seems to be spreading to nonAnglo-Saxon economies. Other stakeholders are seen as groups who need to be satisfied if the shareholders' interests are to be met. Dissatisfied customers and employees are unlikely to be consistent with high returns for shareholders. This focus on shareholder value has been seen in terms of increasing use of present value and economic value techniques. These techniques are seen as mechanisms for determining internal policy which will lead to significant impacts in the capital markets. The components of shareholder returns are capital gains and dividends. The management

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TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

of the business can have some impacts on dividends but the relationship between dividends and shareholder value has always been debatable since the seminal work of Modigliani and Miller. The internal policies focus on creating capital gains. However, the relationship between internal policy and capital gains has always been seen to be more complicated than that implied by the various theories of efficient markets: such theories suggest that policies which improve present value lead automatically to share price improvements. The increasing use of economic value and present value are seen as the mechanisms to deliver shareholder value. However, the way in which policy is judged and the techniques of economic value and present value are seen as ways to ensure that correct financial returns are obtained. Financial monitoring and analysis are thereby mechanisms to ensure that policy is directed towards what are seen as the goals of the organisation. Finance does not, in general, provide the impetus as to what an organisation should actually do. It is the set of strategies and policies of the business that ultimately create value. Finance officers seem to be uncomfortable with any perspective difficult to tie immediately to financial returns, such as marketing, quality improvement or investments in information technology. These types of policy are, however, the core mechanisms by which some businesses achieve financial returns. There should be a creative dynamic between finance and the other functional specialisms. These relationships can be difficult for finance officers to capture and understand. The technique of the balanced business scorecard has provided a framework for relating finance and strategy in the past few years. It was developed by Kaplan and Norton in the early 1990s to provide a strategic information system. The idea is to ensure that strategy is developed to a level at which it can be assessed by a set of measures that consistently encompass the activities of the business. There may be tiers of management information relating the policies of different levels of the business to the overall strategy. The scorecards are related to different perspectives of the business and Kaplan and Norton have suggested the use of four: learning and growth; internal business processes; customers; and financial and at every level each scorecard perspective should have between five and seven measures. Every business, when formulating its strategy should have aspects relating to the four scorecard perspectives which gives elegance to the method. Since change is an essential part of businesses the learning and growth perspective ensures sufficient focus is concentrated on organisational development. Any business delivers its products through internal processes and so these are a vital element of any strategic perspective. It is essential for a business to satisfy its customers and therefore a measurement system that relates to customers provides an important element in strategic policy management. The financial perspective can, in part, be seen as an objectives perspective, but it is important to be aware of how exactly the financial results are

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INTEGRATING TRANSFER PRICES WITH ORGANISATIONAL STRUCTURE

generated and thus the financial perspective may represent mechanisms for obtaining overall financial results as well as the results themselves. A number of different themes and perspectives may be developed on this basic framework but whatever the precise content of scorecards they provide a structure for integrating financial and non-financial information. The role of transfer pricing systems must be viewed as part of this strategic perspective. Although there are a number of recommended financial perspectives for an organisation such as business units, traders, distribution channels, customers and products, any information should be presented within a sensible overall strategic perspective. The balanced business scorecard can provide a sensible framework within which to develop the management information systems.

THE INTERRELATIONSHIPS OF UNITS In this section the interrelationship of different business perspectives is considered. The units can be any perspective of the business such as products and customers as well as business or budgetary units. Transfer pricing in essence provides links between different business units and defines in a quantitative way the nature of the relationship between different business units but there are issues of interpretation to be considered. The clarification of such issues can be far from obvious and the point is best dealt with in terms of specific examples. The examples used are: transfer pricing in relation to units which underwrite or take on risk, customer financial analysis and the funding decision. It is an important generalisation that if one puts two sets of risky returns together the risk embodied in combination diminishes unless the cash flows vary together directly; the precise nature of the decrease varies depending on the definition of risk. In general, the conditions where the combinations of two sets of returns do not lead to some diversification of risk are mathematically very specific. If risk is defined by the standard deviation of returns on a portfolio then risk will be reduced provided the correlation coefficient of the returns on the two component portfolios is less that one and, in practice, this is nearly always the case. In the case of other definitions of risk, for example Value at Risk, the conditions are slightly different: here combinations of returns lead to reduction of risk unless the observations of low returns coincide in time. If one considers a unit that takes on risk for a financial organisation, be it distribution channel, underwriter, dealer, product or customer, these activities will alter the risk profile of the business.

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TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

One possible motivation for transfer pricing occurs where certain types of risk are concentrated in a treasury or risk management function. If this is the case, the units considered above have no overall function in managing risks. The returns they receive and the costs they incur create transfer prices which do not relate to the overall risks of the total organisation. In this situation the creation of transfer prices is motivated by a desire to centralise risk management responsibilities. However, the result will be that individual risk-taking units may not behave in a way congruent with the management of risks in the whole organisation. A system which did provide an appropriate set of prices and incentives for the units would almost certainly dilute the ability of the organisation overall to manage risks. There is no solution to these problems and how pertinent they are depends on how an organisation chooses to manage risk. Another example concerns the relationship between a customer and a retail financial services organisation. The impact of a customer to an organisation is always marginal. When an organisation takes on an additional customer it is very unlikely to have any resource implications that are measurable except in relation to financial inputs. If that customer takes a loan, for example, it will be relatively easy to quantify the funding implications. However, it will not be possible to trace the impact of the customer on organisational manpower in all the functions whose activity is impacted by him or her. In allocating costs or levying a transfer price some judgement must be made on the level of impact that can be considered marginal. If the organisation were to take on a thousand customers instead of one the impact might be more visible. In order to produce meaningful financial information it is necessary to choose which costs or transfer prices to include. In general, organisations focus on the impact of a thousand customers when looking at one and make that customer bear the average weight of any cost impact. Here again the type of transfer price or cost allocation is a matter of judgement; such judgement should relate to the usage made of the information. In analysing the impact of a decision one should include both the cashflows based on the decision and any funding implications which arise. In terms of non-financial organisations, the standard way of undertaking this type of analysis is to use the adjusted present value approach. The value of the cashflows based on the decision is presented as if it were equity funded, the cost of equity depending on the risk involved in the decision. The next step is to make an adjustment for any funding implications which may impact on the value of the project. In considering a financial decision slightly different considerations may need to be taken into account. One role of financial organisations is to raise finance. If the project raises funding these funding flows should be seen as part of the cashflow of the project as should any funding costs associated with them as these are in essence cashflows

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INTEGRATING TRANSFER PRICES WITH ORGANISATIONAL STRUCTURE

associated with the decision. If the organisation can obtain funding in a way which is superior to the capital market, this may be due to some competitive advantage the firm has in raising funds. If there is additional debt funding this should be dealt with in the standard manner, i.e. estimating the present value of any tax advantages over equity funding and adding them to the present value of the project. This treatment of the project has one important omission that is related to interest rate risk. If the treatment involves lending and borrowing there may be a maturity mismatch and if the balance sheet of the decision is unbalanced there will also be a need to deal with this imbalance while not creating an interest rate risk. The standard way to deal with these issues is to attribute specific matching capital flows and interest revenues which will eliminate the interest rate risk element, and this should be done in such a way that any funding advantages for the organisation should be revealed in the calculation. If there are returns to the interest rate risk they would be located in the treasury or risk management section. Some decisions for financial institutions may be sufficiently important to lead to a change in credit rating. These impacts in terms of any funding costs should also be included.

CONCLUSIONS This chapter has attempted to outline some important overall issues which must be considered if a successful system of transfer pricing is to be established. Whatever the purpose of transfer pricing systems they should accord with the strategic information needs of the institution. They should be appropriate for the purpose and should be established by those who understand the organisational role that they are designed to fulfil. There are many issues that must be considered if transfer pricing is to avoid creating dysfunctional incentives and the examples given on risk underwriting, relating information to decisions and using appropriate rates of interest highlight some examples of these issues.

39

6 Attitudes to risk INTRODUCTION In considering transfer prices for financial institutions the prices used can be divided into five different categories. These are: operating expenses-based transfer prices; transfer prices for funds; risk-adjusted performance measures; transfer prices for capital; and transfer prices in relation to derivatives. The first of these categories does not require the consideration of risk issues while the others depend on attitudes to risk. Many of the problems which arise through deciding on adequate prices for these other four categories depend on having a sensible attitude to risk. This chapter reviews the traditional attitude of finance theory to risk and how its limitations have led to the development of different perspectives for risk analysis; many of these developments have been led by the business rather than the academic community. It would also be fair to comment that, as yet, these different attitudes to risk have not been incorporated into a sensible unified framework. There is no one single perception in relation to risk of how transfer prices should be generated and so there are a number of different but not necessarily consistent views as to how certain types of transfer prices should be generated. This thesis will be enlarged in later chapters.

THE TRADITIONAL VIEW OF RISK This section discusses the accepted academic views of risk and considers whether they are entirely adequate to an understanding of the issues of risk in relation to financial institutions. It gives a very general description of their propositions and provides some critical analysis which is the basis for the developments discussed later in the book.

Portfolio theory The initial view of risk which forms part of the accepted body of financial knowledge is that of Markowitz (1952, 1959) which outlines what has subsequently been referred to as portfolio theory.

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The essence of that view is that investors are interested in the expected returns and the standard deviations of returns on their portfolios of investments. Investors are considered to be risk averse which means that their utility is increasing in expected returns and decreasing in standard deviations of returns. Where they construct portfolios from a combination of different securities they will diversify their risks since the variance of the portfolio returns is less than the linear combination of the variances of the returns of individual securities, provided the returns on the securities do not have a covariance equal to one. Investors, as part of their utility-maximising behaviour, will diversify their portfolios to eliminate the degree of the risk associated with the individual investments. In its initial formulation every individual would invest in all the securities available to them and this conclusion is derived from the absence of transaction costs in the model. The conclusion is obviously invalid in the real world but it is argued that the bulk of the benefits from diversification could be obtained with considerably fewer than all the available securities. However, to take a well-known example, many investors do not have well-diversified portfolios. The level of international diversification of investors resident in countries other than the United Kingdom and the Netherlands is in general low and so it is interesting to postulate whether many investors have obtained all the diversification available to them even considering the issue of exchange rate risk. (Jorion 1985,1989,1992)

Asset pricing models The major asset pricing models are based on the central conclusions of portfolio theory. It is argued that investors will diversify to eliminate certain risks and that the only risks for which they need compensation are those that are not diversified in their utility-maximising portfolio selection. They distinguish between asset specific risk and general risks. Asset specific risks are automatically eliminated by portfolio construction while general risks cannot be eliminated without cost. The differences between the theories relate to the measurement of specific and general risk and how risk premia are calculated in relation to those risks. The best known and most commonly used asset pricing model is the capital asset pricing model (CAPM) which was derived by Sharpe (1964) and Lintner (1965). The CAPM defines the required return on an asset in terms of the CAPM as given by equation 6.1.

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E(Ri) = Rf + bi(Rm ± Rf)

[6.1]

Where the required expected return on an asset E(Ri) is composed of the risk free rate of interest Rf plus a risk premium. The risk premium comprises a measure of risk bi and a price for risk (Rm ± Rf). The measure of risk is outlined in equation 6.2.

bi =

COV(Ri,Rm) VAR(Rm)

[6.2]

The b (beta) of security (i) is the covariance (COV) of its returns with that of returns on the market portfolio divided by the variance (VAR) of returns on the market portfolio. It is calculated in terms of the slope of a regression line where Ri is regressed on Rm. It is a measure of the degree to which a change in the market return is reflected in the return of the particular asset (i). The price of risk is the difference between the return on the market and the risk free rate of interest (Rm ± Rf). The measure of risk b is based on the variance of the factor which is seen as the underlying driver of risk which is the market return and the degree to which it influences the returns on the particular asset under consideration (i). The model is based on a vision of investor utility determined by expected values of returns and standard deviations of returns. It is thus consistent with Portfolio Theory. There have been many reservations expressed as to the validity of the CAPM and the academic community has become more attracted to the arbitrage pricing theory (APT) of Ross (1976). This model distinguishes between general and security specific risk in terms of a number of factors. It does not, however, theoretically specify the factors which describe general risk since they are the result of statistical investigation. Neither does it make the kind of restrictive assumptions in relation to the portfolio composition or investor utility that are made by Portfolio Theory and the CAPM. Despite its many advantages, arbitrage pricing theory has not been generally adopted by the business community, quite possibly because of the relative ease of motivation of the CAPM. Measures of risk (b) can be obtained from published sources for most large companies and the equivalent measures for the APT must be calculated from a specific risk-based model.

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Market efficiency When considering the standard theory of finance it is necessary to pay attention to the question of efficient markets. Although these are less related to the preferences of investors with regard to risk, they are important in understanding why businesses devote their energies to risk management. Fama (1965a and b, 1970) outlined the core theory of market efficiency. In an efficient market it is impossible, on average, to obtain a return in excess of that required by the market for undertaking a certain level of systematic risk. In essence, the level or type of market efficiency is determined by the type of information incorporated into prices. Fama suggested a threefold classification of forms of market efficiency: weak, semi-strong and strong. These three levels correspond to different levels of information which are incorporated in prices. For the weak form all past and present market prices are incorporated into the current market price, for the semi-strong all publicly available information is incorporated into prices and for the strong all relevant information is incorporated into prices. It is generally believed that few markets are of the strong form. It is therefore possible to argue, for example, that the interest risk situation of a bank is not public knowledge. Management in this position will not be amenable to the shareholders through diversifying their portfolios. Analagous arguments can be made for other risk management perspectives. Information efficient equilibria gives another perspective on this analysis. (Grossman and Stiglitz 1980) In this context, investors are divided into those who seek information and those who do not. The equilibrium choice between the two groups will be achieved when there are no abnormal returns for either group. Under the efficient market hypothesis there are no abnormal gains on offer for investors when these are achieved.

MARKET-BASED ATTITUDES TO RISK Financial management within the individual firms should use the capital market as a test for the required returns in the business. Under the theory of transfer prices, outside prices are usually the ones considered appropriate for internal transfers unless there is some reason for believing the firm has power within the market place. The calculation of present value or economic value requires an estimated funding cost that should be related to the market price for those funds appropriate to the capital markets. The treatment of term and currency lending giving different interest costs reflects this use of outside market prices. The use of these prices reflects the judgements of the markets in relation to risk irrespective of the factors which determine prices or rates of return.

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Value at Risk (VAR) Where distributions of returns are normal the distribution is exactly characterised by the expected return and the standard deviation of returns, which means that portfolio theory accommodates risk adequately. If the distributions of returns are not normal then the exact specification may require additional moments of the distribution. The conventional definition of risk in finance is as a measure of the spread of return outcomes. This is not a particularly intuitive definition of risk and it is quite conceivable that investors may be interested in the adverse end of the distribution of returns. The most important development in recent years relating to the measurement of risk is the concept of Value at Risk (VAR). One definition of the concept is: The Value at Risk is the loss over a particular time period which will only be exceeded in a certain proportion (a%) of cases. Figure 6.1 illustrates the distribution of returns from a particular portfolio of financial obligations and so demonstrates the concept of Value at Risk. The average return for the time period under consideration is E(Rp) and x is a cut-off level of returns. This cut-off level is determined by the definition of a% and there are only worse returns than x in a% of cases. The VAR is defined mathematically by equations 6.3 and 6.4. Relative Value at Risk = (E(Rp) ± x)

[6.3]

Absolute Value at Risk = (0 ± x)

[6.4]

The relative Value at Risk is the difference between the mean return and the cut-off value which is only exceeded in a% of cases. If x is negative the value of losses is added to the average return to give the relative Value at Risk. The absolute Value at Risk measures the level of losses at the cut-off value x. The Value at Risk is usually expressed as a certain value of money over a certain time period, but it can also be expressed in terms of a percentage of the portfolio value. The simplest way to characterise Value at Risk is as a `worst case in normal operations'. Consider a portfolio of financial obligations and the returns from that portfolio that can be measured over a number of different time periods. A number of arguments are taken into account when deciding on the time period for the Value of Risk calculation: the most important of these are likely to relate to the liquidity of the obligations and any regulatory enactments. Value at Risk is sometimes

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Figure 6.1 Defining Value at Risk.

identified with worst case losses and this implies that the losses can be capped at the Value at Risk. In this case the position can be liquidated. If, for example, it would take a day to sell the portfolio then the appropriate time period to be considered would be a day. The market risk amendment which can be applied to portfolios of the market risks of a major bank suggests a ten-working day time period for Value at Risk, so the institutions subject to those regulations would then adopt that definition of the time period. The other major issue in measuring the Value at Risk is to decide a value for a. It will depend on the attitude to risk of the financial institution or the regulatory enactments. The market risk amendment suggests a value of 1% for a. Value at Risk has become a key risk measure and it is interesting to ask exactly what type of risk measure it represents. If the distribution of the portfolio of obligations is normal then the Value at Risk is only a multiple of the standard deviation of the distribution of returns. (Dowd 1998) In essence, if this is the case, nothing is added to Portfolio Theory. In some motivations of the technique the assumption of normal distributions of returns is made and here the technique and definition of risks add little to traditional theory. As in the case of many managerial measures its real advantage lies in the fact that it presents data in a way which gives busy managers with little technical expertise an intuitive understanding for some issues. In the case of portfolios of different types of investment assuming a normal distribution of returns often proves to be an inexact characterisation of the likely distribution. If portfolios contain any optionality or if one considers a loan portfolio in relation to credit risk then it is very unlikely that the distribution of returns will be normal. Value at Risk is then a more useful measure and may give additional information to that provided by the standard deviation of the distribution of returns. The

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calculations of Value at Risk must accommodate non-normality so they must be estimated by the historical and Monte Carlo simulation techniques. (Dowd 1998) Historical estimations of value at risk are based on using actual data to create distributions of returns to which the Value at Risk methodology is applied. Monte Carlo simulations are based on specifying the distribution from which individual returns are generated. Then a set of simulations is run to derive the overall distribution of returns: this forms the data for the estimation of the Value at Risk. The extent to which Value at Risk can form a sensible vehicle for the analysis of financial crises depends on how the distributions of returns are set up. Monte Carlo simulations, stress testing and extreme value modelling provide an insight into the possibilities of extreme events. These do not necessarily require the Value at Risk framework and the Value at Risk calculations do not necessarily refer to these perspectives. In conclusion, although Value at Risk can provide a simple measure of risk its exact nature depends on how the context of Value at Risk calculation in terms of time periods and cut-off values is defined. It also depends on what types of portfolios of obligations are the subject of Value at Risk. There are a diversity of measurement techniques associated with Value at Risk measures and the validity and application of each one impacts on exactly what is measured by Value at Risk. Value at risk is a worst case measure of risks: it adds to the types of measures of risk especially when applied to collections of financial measures whose returns are not linear. However, its nature depends on the way it is applied and measured and since there is no definitive methodology in its application the term will always be surrounded with a degree of ambiguity.

Worst case One of the interesting perspectives of the market risk amendment is that the capital requirements for market risk exceed the defined Value at Risk measured in terms of a 1% cut-off value defined over a ten-market day time period. It allows banking institutions to use their own modelling capabilities but imposes capital requirements in excess of the Value at Risk, which is multiplied by a factor of three. The internal return on risk adjusted capital (RORAC) systems of some banking systems allocate capital to activities on the basis of desired credit ratings. The appropriate value at risk cut-off percentage is worked out from the default rates related to certain levels of credit rating.

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In most normal calculations of Value at Risk the data used come from the historical experience of the behaviour in the values of financial obligations but it is possible to consider worst case issues in terms of Monte Carlo simulations or of other scenarios that are more specific. Since most Value at Risk calculations are based on current or normal circumstances they may not capture worst case scenarios which would need to be calculated separately. There are always circumstances in which there is the possibility of default for any financial institution. The financial system may be so unstable that it leads to regulatory, governmental or international intervention. In cases where intervention is required to underwrite the financial system then the institution may feel comfortable with the risk which it is undertaking. In a situation short of general financial crisis the attitude to risk may be different. An underlying argument in favour of regulation runs that shareholders and managers may not consider adequately the impacts of risk since these impacts involve externalities. In these circumstances the regulators will force the financial institution to be more prudent than it would otherwise be.

Value at Risk, worst case and shareholders If one considers the motivation for risk management within an organisation it is obvious that regulators and managers may be more interested in the subject than are shareholders. Managers find it difficult to hedge their risks to the institution in which they work and regulators are worried about the impacts of failure for financial institutions partly due to the externalities to which they give rise. It is certainly the case that some risk and organisational management systems appear to be particularly risk averse and these issues are explored in some detail in the chapters which consider risk adjusted performance measures (RAPMs). However, shareholders can certainly be interested in adverse case definitions of risks such as worst case or Value at Risk. As yet the empirical justification for these propositions is rather weak and, in understanding required returns, finance theory has not considered these issues.

Investor time perspective Traditional finance theory has not dealt entirely adequately with risk from the perspective of time. The information outlined in Table 6.1 details long-term returns for US financial markets. The standard view of the assets considered in the table is that shares are the most risky, bonds less so and bills the least risky of these investments. The standard deviation of returns in relation to a single-year

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Table 6.1 Real returns on US financial assets 1802±1996 Average return Asset Shares Bonds Bills

6.9 3.4 2.9

Standard deviation 1 year holding period 18.0 8.5 6.0

Standard deviation 20 year holding period 2.7 3.0 2.8

holding period appears to substantiate this view of risk, because the standard deviation of returns is highest for shares, intermediate for bonds and lowest for bills. The situation for a holding period of 20 years is radically different: the differences in the standard deviation of returns are much less with the values being quite close to each other. There is also a different order in relation to risk: shares are the least risky, bills intermediate and bonds the most risk of all. If there is a relationship between risk and return where higher returns compensate for higher risk it appears to apply for shorter rather than longer holding periods. These views are based on circumstantial evidence but the data appear to give support to the contention that the market may only reflect a specific set of risk preferences in relation to certain time periods for risk which are considered important for the investor. The measurements of risk illustrated in Table 6.1 indicate that different temporal holding periods give different values for risk measurement and a comprehensive treatment of risk should take holding periods into consideration.

CONCLUSIONS Traditional finance theories which deal with the attitude of investors to risk do not appear to deal adequately with all the aspects of risk, especially where distributions are not normal. Their success at modelling the relationship between risk and return is not entirely satisfactory. The CAPM appears to be empirically flawed and the arbitrage pricing theory is unlikely to be successful partly because it does not provide an adequate framework in which to consider risk and partly because it relies on the outputs of a statistical investigation. The definition of risk in terms of variance of return while approved by the statistically minded does not seem to recommend itself to managers generally. This was one of the reasons for the development of other measures of risk, notably value at risk and worst case scenario. There have been no attempts to use value at risk and worst case scenario to explain risk-adjusted returns in financial markets, but they have been employed to estimate capital

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requirements and have provided the basis for establishing capital charges in financial institutions. The key question as to whether shareholders are interested in Value at Risk has not as yet been investigated. Attitudes to risk both of academics and of practitioners are currently in a state of flux and there are many unanswered questions. It follows that establishing what is an appropriate return for a given level of risk can only be done with some caution. This caution is reflected in the following chapters which deal with specific transfer prices.

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Part 3: Specific transfer prices This section of the book considers the issues surrounding specific transfer prices for financial institutions. In Chapter 7 we consider transfer prices that are based on an understanding of operating expenses. Chapter 8 deals with the transfer price of funds, Chapter 9 provides a critical review of risk adjusted performance measures and Chapter 10 deals with the issue of capital allocations and the associated pricing. Chapters 11, 12 and 13 discuss various risk adjusted performance measures. The final chapter of this section considers the presence of derivatives and how they can be priced sensibly. The section does not provide a blueprint for the introduction of such pricing systems: rather, it surveys the problems of each system and gives an attempt to resolve the issues from a practical perspective.

7 Transfer prices based on operating expenses

INTRODUCTION One of the most difficult perspectives of any transfer pricing problem is the understanding of the operational cost structure of the organisational units that underlies a transfer price. The standard economic concepts of variable and fixed costs do not easily emerge from any costing exercise. In essence, one needs to understand how costs behave and this is as much related to the psychology and culture of the organisation as it is to any economic perspective. The diversity of accounting responses to transfer pricing reflects, to some extent, the difficulty of understanding how costs behave. Costs can be considered to behave as an ocean liner does: they will continue to move in a particular direction unless some powerful countervailing force is applied to change their course! Costing is an accounting technique which has gradually developed over a number of years and today gives a sensitive perspective on the nature of costs and how they change within an organisation. The ability to attribute costs to the objects of transfer pricing is a necessary part of any comprehensive and sensible transfer pricing system. This chapter focuses on the most recent aspect of costing, i.e. activity-based costing, how it improves on the costing methods that it replaced but is still not entirely efficient for the purpose of generating sensible transfer prices.

THE PRINCIPLES OF ACTIVITY-BASED COSTING In arguing for the benefits of activity-based costing Kaplan (Kaplan and Atkinson, 1989) has suggested that the previously dominant cost-allocation techniques were based on an insufficiently sensitive relationship between costs and cost objects (such as products, organisational units and

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Costs

Activities

Drivers

Objectives

Figure 7.1 Overview of activity-based costing. customers) through very approximate and progressively less accurate systems of allocation. Activitybased costing, it was argued, was much more sensitive in the allocation process. In particular, it was considered that the previous techniques were poor in their understanding of issues concerning product diversity, variety and overhead expenditures. The problems of the previous systems were magnified due to the development of production processes where material costs were declining as a proportion of total costs. Activity-based costing was seen as a more subtle and sensitive way to understand and manage the costs of an organisation. If activity-based costing becomes the basis for cost management then it is likely to be a better basis for understanding how costs change and therefore for establishing operating expenses-based transfer prices. An overview of activity-based costing is given in Fig. 7.1. The use of the term activity in the context of activity based costing is different from that used in other chapters where it corresponds with that of cost objects used in this chapter. The only justification for an organisation undertaking costs is that they are needed to perform an activity that contributes to the purpose of the organisation. Costs under the technique are associated with particular activities and the levels of activity are determined by the cost drivers. These can be counted and an average cost per unit of driver calculated. The number of units of a cost driver can be linked to the cost objectives that are the final units of analysis. In this way costs are related to cost objectives. The best source for activity costing in relation to financial institutions is Julie Mabberley's book on Activity-based costing for financial institutions which gives a very comprehensive treatment of the subject with a particular focus on financial institutions. These ideas can be more easily understood when more specific examples of activities, cost drivers and cost objectives as illustrated in Fig. 7.2 are discussed. The initial core data for a particular financial activity (for example the budgeting or planning) are collected. In establishing any activity-based costing system the level of detail embodied in the activity list (to which the costs are related) must be established. The level of activity can vary and between 30 and 4 000, different levels being used depending on the purpose of the activity-based costing exercise. The activities in Fig. 7.2 represent a wide range of possible choices for cost analysis. The activities shown are those typically found in a finance department and correspond to the cost drivers on a one-to-one basis. The cost objectives in the third column are derived from the

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TRANSFER PRICES BASED ON OPERATING EXPENSES

Activities

Cost drivers

Cost objectives

Producing financial accounts

Legal requirement

Products

Producing management accounts

Management requirement

Customers

Financial analysis

Number of decisions requiring analysis

Distribution channels

Capital appraisal

Number of capital projects

Organisational units

Payments processing

Number of invoices received

Business units Processes Decisions Projects

Figure 7.2 An example of activity-based costing for the accounting department.

information in the first two and do not have a similar correspondence with them as the first two columns have to each other, since a particular cost can be allocated to a number of different objectives. The accounting department may be involved in a number of capital appraisals, for instance as custodians of the appraisal process and to provide analytical backup to ensure the proposals have financial justification. The resources involved in these activities can easily be identified and will be part of the activity of capital appraisal. The organisational factor which determines the quantity of resources attributed to capital appraisal will depend on the number that are required in a given period of time which means that the cost driver here is the number of capital appraisals. If one has identified the resources used in capital appraisal it is easy to derive an average resource per appraisal in the time period under consideration. This rate is then used to allocate the costs to particular cost objectives. Capital appraisals are associated with a variety of cost objectives such as particular products, distribution channel outlets, processes and projects. Costs are allocated on the basis of an average although the resources needed for different project appraisals may vary widely given the level of detail of the analysis. Often the problems in relation to these cost analyses can be found only by an understanding of the specific detail of each particular scheme.

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TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

THE DISTINCTION BETWEEN TRANSFER PRICING AND COST ALLOCATION The cost-allocation process that is illustrated in Fig. 7.2 is very similar to transfer pricing. The issues are discussed, for example, by Emmanuel and Mehafdi (1994). In this book a more general definition of the concept of transfer pricing has been adopted and the types of costing systems, the allocation of costs and establishment of transfer prices are described in relation to services provided to other organisational units. The underlying costing techniques are identical.

PROBLEMS IN USING ACTIVITY-BASED COSTING INFORMATION AS PART OF A TRANSFER PRICING SYSTEM Activity-based costing is justified because of the more accurate way it allows costs to be associated with cost objectives. However, the concept does not solve all problems in understanding how the costs of an organisation behave. Activity-based costing does not focus on any version of the distinction between fixed and variable costs and so does not necessarily provide good information on which to base transfer pricing. Over the years accountants have attempted to grapple with a number of issues concerning the determination of costs of which the most important is how costs are driven. There are few costs that vary directly with volume in financial services organisations, for instance, in order to write a cheque one has to use the paper on which the cheque is written as well as the printing on the cheque. This example illustrates some of the issues in applying costs in a transfer pricing perspective. It is a rare example. There is, in many cases, a relationship between costs and volume which is dealt with by the concept of step costs. Costs do not change until a certain level of operation is reached then there is a sudden change in the level of costs. Another consideration is the time period over which costs change: in the short-term they may not vary with levels of activity but over time they may be more responsive to changes in volume. Perhaps the most important factor is that many changes in cost emanate from decisions by management. A good example of this is given by changes in headcount, because in many organisations the decision to employ extra labour or make employees redundant is a specific one which would not automatically result from a change in volume. There are some processing operations where there are different groups of staff whose levels of work depend on activity, so it is possible for some operations to make employment costs variable.

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Activity-based costing does not naturally distinguish between different types of cost. Its central idea is to relate costs to activities and activities to activity drivers for cost allocation and there is no differentiation between fixed and variable costs in this exercise. It appears to be similar to allocating total costs. The methods by which costs are collected for an activity-based costing system can be modified to take account of any desire to categorise costs further in relation to their variability. Indeed, many activity-based costing exercises are undertaken to make costs more sensible to activity levels, in other words, to make the costs variable. Costs can be brought together within the following framework which gives a degree of flexibility to understanding them. These cost categories are the following: directly variable costs; managerially variable costs; cost object specific fixed costs and overhead costs. Directly variable costs vary directly with volume: the example of the paper on which a cheque is written is an example of this type. Managerially variable costs require a decision by management for them to be variable. They change but do so over a longer time period than those which are directly variable. Manpower costs in a telephone sales operation exemplify these. Cost object specific fixed costs are those related to a specific cost objective such as those listed in the right hand column of Fig. 7.2. They include marketing expenditure in relation to a product. Finally, there are overheads such as the costs of a corporate strategy department. These distinctions in cost collection operations enhance the flexibility with which information can be developed. There are a number of choices in relation to the development of transfer pricing and these can be explored more adequately, the more flexible the information-gathering system.

THE USES OF COST-BASED INFORMATION FOR TRANSFER PRICING There are two types of transfer pricing systems for financial organisations. The first group includes financial assets, liabilities and obligations and the second those of operating units. Operating cost data can be applied to transfer pricing for both groups. The more the transfer pricing is based on the cost information related to financial obligations the more accurate it is likely to be. Although activity-based costing is an improvement on previous systems of cost allocation it is not totally accurate where transfer pricing requirements are considered and should always be treated with caution. It is much more difficult to understand the nature of operating expenses and how they vary than it is to understand the impacts of financial obligations and financial markets on an organisation's costs and revenues.

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CONCLUSIONS ON THE USE OF COSTING INFORMATION Costing information is always approximate. Organisations do not have an exact understanding of how their costs operate. Even activity-based costing systems are not entirely accurate in supporting transfer pricing. This problem is more acute in relation to transfer pricing between operational organisational units since the entire bases of the transfer pricing system may be derived from the costing system. In the case of financial obligations and the costs and revenues of their market conditions the accuracy of the costing system is less important and costs can be more precisely understood. For this reason the costing of financial products derived from the transfer pricing information for financial obligations should be much more sensible and accurate.

COMPARING FINANCIAL AND NON-FINANCIAL ORGANISATIONS The usefulness of any transfer pricing system depends heavily on an understanding of cost and revenue functions. Most commercial systems of transfer pricing depend on understanding of the basic material costs in production, i.e. those relating to the process of production, distribution and administration. The material costs can usually be quantified in a way which leads to accurate comprehension of the cost structure but the other costs are more difficult to perceive clearly and estimate. In most organisations the proportion of material costs to total costs is declining and therefore understanding the cost structure is increasingly difficult. It therefore follows that any system of transfer pricing is becoming progressively more exacting to implement successfully. In the case of financial organisations the situation is rather different. The proportion of financial obligation-based costs is increasing and is a higher proportion of costs than are material costs. This means that, in general, financial institutions have a better understanding of their cost structure than do other types of enterprise and therefore a better ability to construct useful systems for transfer pricing.

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8 Transfer pricing the cost of funds: a general perspective

INTRODUCTION This chapter outlines the most important techniques used by financial institutions to provide a transfer price for funds. It surveys the current practice and recognises that institutions are becoming increasingly sophisticated. The institutions with simple balance sheets may be able to use simple techniques, (Drury 1994) but all institutions are becoming increasingly complicated and moving toward the more intricate techniques which are outlined in this chapter. This movement is the result of a number of factors: the increasing ease of computation; the escalating complexity of financial institutions themselves and the enhanced role for risk management due in part to regulatory developments.

BORROWING AND LENDING, INVESTING AND FUNDING A core part of the activities of the vast majority of financial institutions is that of acquiring funds and investing them. If these activities are undertaken in organisational units which do not have matched balance sheets (i.e. the value of their lending does not equal that of their borrowing) then they can only be assessed from an overall financial perspective with the aid of transfer prices in relation to funding. Even if they do have matched balance sheets there may still be issues in relation to market risk that will be dealt with more adequately if there is a system of transfer prices. The transfer price for funds is taken to be shorthand for a price that can be used to judge both the profitability of funding and lending, and may separate out from the management and returns to taking interest rate and currency risk. These two prices do not need to be the same since there may be

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a return on the management of interest rate and currency risk. We are therefore considering a notional revenue which can be attached to funding and a notional cost which can be related to lending. The more simplistic of these systems have been used in retail financial organisations and are described in Khanna (1985), Kawano (1990), Chu Yang (1989) and Drury (1994). They outline different types of funds transfer pricing and are listed below: . Single pool ± average rate method . Single pool ± marginal rate method . Multiple pool method . Predetermined margin . Individual transaction Each of these can be considered in detail.

Single pool ± average rate method The single pool ± average rate method puts all funding into a pool and takes the average rate paid for those funds as the transfer price. This method has many drawbacks. The average rate is never the rate which would be identified by any present value maximising system since it does not discriminate on any marginal decision. It does not distinguish term or risk and so does not reflect the important attributes of funds recognised by financial markets through differential pricing. It is only likely to be a useful tool where the organisation using this technique has a very simple balance sheet, for example where all the funding is at a variable rate. In general, where it is used, it does not consider issues of operating expenses which may be important. Currently, there are only a few small and unsophisticated institutions using this technique, mainly savings and loans.

Single pool ± marginal rate method The single pool ± marginal rate method puts all the funds into one pool and uses what is considered to be a marginal rate of funding: for example, the three month London Inter Bank Offer Rate (LIBOR). This is an improvement on the average rate insofar as it reflects marginal rather than average considerations. However, it does not deal with issues of term or risk, normally important

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elements in the price of funds. Again it may be useful in a very simple environment where the issues of risk and term are unimportant. However, there are no institutions which now can afford to ignore the risk implications of the funding decision, although this may be dealt with through a system of interest rate risk rather than by means of a transfer pricing system.

Multiple pool method The multiple pool method allocates prices to individual funds dependent on their characteristics. The funds are allocated to a particular pool which has a specific rate. The system can be very simple with only a few characteristics to allocate funds or may be developed in great detail and have many different rate-related properties. In this way the method can categorise funds in terms of few or many different pools of funds. There are many different ways in which it can deal with a balance sheet that has a degree of funding mismatch in terms of different transfer pricing categories and does not have to develop a view on matching funds and loans. In general, the most sophisticated financial institutions use some variant of the multiple pool method as the basis for their transfer pricing: one of these, the industry standard approach is described in detail below. However, there are problems associated with many multiple pool-based transfer pricing systems: for instance, they do not deal adequately with all the issues of term and risk since they sacrifice some detail for simplicity.

Predetermined margin The predetermined margin technique requires an addition to the cost of funds which is a mark-up to the marginal or average cost of funds as identified by the other methods described above. In common with any system of mark-up pricing level for the mark-up must be decided. The use of some marginal based individual transactions, given a number of assumptions, seems the most sensible course for setting transfer prices, and it is unlikely that a mark-up system will replicate these results. The sophistication of systems for transfer pricing has developed over time with the growth of computer technology, analytical understanding in organisations and the increasing complexity of businesses. This is especially true of retail banks. The growth of regulation has also contributed to these developments and the market risk amendment has provided a strong additional impetus to sophistication in transfer pricing systems of banks.

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Figure 8.1 Transfer pricing term and currency.

Transfer pricing has evolved from a single interest rate transfer price to the establishment of pools for different terms of funding with transfer pricing for each term on the balance sheet. The inclusion of currency differences has extended this picture to every currency represented on the balance sheet. An overall picture is illustrated in Fig. 8.1. The transfer pricing system is based on the currency and term of the asset and liability. Thus if a banking unit makes a fixed rate two year loan in yen the transfer price which is applied to the loan to estimate its profitability is that on two-year yen funding. This isolates the operational unit from interest and currency risk considerations. The funding of the loan will be allocated to the mismatch unit, be it treasury or corporate funding. (Chittenden 1996) The use of this type of transfer price makes sure that, at least in notional terms, currency and interest rate risk are taken away from the operational units and located in a centralised function. Chittenden (1996) explores some of the implications of this system of transfer pricing for the centralised mismatched unit. He distinguishes between profits for current risk in the treasury function and profits from historical risk management. The basic distinction is outlined in equations 8.1 to 8.4

where :

Profits in Mismatched Unit = Current Risk Profits + Historical Risk Profits

[8.1]

Profits in Mismatched Unit = TVOA ± TVOL

[8.2]

Profits from Current Risk = TVCA ± TVCL

[8.3]

Historical Risk Profits = (TVOA ± TVCA) ± (TVOL ± TVCL)

[8.4]

TVOA

= Total value of transfer pricing income from current asset evaluated at initial term to maturity.

TVOL

= Total value of transfer pricing cost on current liability evaluated at original term to maturity.

TVCA

= Total value of transfer pricing income from current asset evaluated at current remaining term to maturity.

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TVCL

= Total value of transfer pricing cost on current liability evaluated at current remaining term to maturity.

Chittenden describes mismatch units profits as composed of two different types of impact. The total profitability is determined by using rates for each element of asset and liability that were appropriate at the time they were incorporated into the bank's balance sheet and these prices govern the flows of interest revenue and receipt over the life of the assets and liabilities for the mismatch unit. The profits do not reflect the current interest and exchange rate risk in the mismatch unit, since that is determined on the basis of current terms to maturity and current rates. The current profitability is determined using the remaining terms and the appropriate rates for those terms. These profits from current risk reflect the current position and should be analytically consistent with net interest income for asset and liability management (ALM) analysis and management purposes. The difference between total profitability and current risk profitability is related to historical risk. The separation reveals the risks which are currently being taken and the impact of risks previously undertaken. It is useful for the evaluation of the mismatch function since it differentiates results of past actions from the current position which one may choose to hedge or not.

Individual transactions The best transfer pricing practice gives a transfer price for each individual transaction that reflects issues of risk, term and the precise time the transaction was taken onto the balance sheet. This allows a very precise understanding of the nature of any profits that arise through funding and lending decisions and how they progress over time and reflects the judgement of financial markets with great accuracy.

TRANSFER PRICING AND TIME There are two aspects regarding the time period to which a transfer price applies and they are indicated in the discussion of Chittenden's work. The distinction between profitability from the historical perspective and that from the current perspective implies that two sets of transfer prices need to be generated; those where obligations were (historically) taken onto the balance sheet and the other when they are taken on at the current time. There are also issues regarding variable rate obligations or obligations which involve repricing, and these must have transfer prices which relate to their current

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situation and term. For these reasons the transfer price applied to a variable rate loan will continually alter with changes in such rates and the transfer price derived from the latest repricing should be applied to repricing obligations. This means that the transfer price for a particular obligation could be the initial price as regards the term of the obligation, the price at the latest repricing point, the current price appropriate to the remaining term or the current variable rate. The appropriate price depends on the envisaged usage and the exact nature of the asset or liability under consideration.

COMMENTS ON TRANSFER PRICING There are some comments which need to be made in terms of these techniques for transfer pricing which are in essence internal interest rate swaps within the bank. In the countries which have applied the market risk amendment the purpose of these systems is to isolate market risk, analyse it and manage it as a separate whole from the rest of the banking activity. This system itself will isolate the market risk associated with financial markets but there are issues which need to be considered. Where the bank sells interest rate products in markets in which it has to change its prices if the quantity of trades increases, there will be a difference between marginal cost/revenue and the interest rate paid/ received. If one considers funding there may be increases in cost for both retail and wholesale markets if one increases the levels of funding. In the case of retail markets it will simply reflect an upward sloping supply curve of funds for the bank. In wholesale markets most individual banks do not have sufficient size to impact on market prices but will still face increases in funding costs since their perceived levels of risk will increase with certain rates of funding. These differences may be important is setting transfer prices in relation to determining the levels of performance. The previous section was based on the view of the market risk amendment and did not deal with the issue of credit risk. If one wishes to deal with credit risks these can also be included within the transfer price. In the case of retail institutions there are a number of further considerations which must be made. The transfer pricing system above implies some strong affinities between wholesale and retail funding. If one is using a wholesale transfer price to judge the profitability of retail financial products one implies that wholesale funding is appropriate for retail lending and wholesale lending appropriate for retail funding. This is certainly the case from some perspectives of a valuemaximising enterprise and marginal costs/revenues for retail should in some sense be the same as their wholesale equivalent. However, there are some important differences between wholesale and

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retail. In retail and small business banking, the bank is a price maker, not a price taker. This may not be a central issue where performance measurement is concerned because the profitability measure will have the actual retail price on one side of the balance sheet and a notional wholesale price on the other. Here the actual price reflects the ability to set prices. However, within interest rate risk there are those risks that are not reflected by a wholesale transfer price. One such is a basis risk because the price for retail funding may vary in its relation to the price of wholesale funding. These risks will not be removed to the mismatch unit and will remain within the operating unit creating those risks. This is a limitation associated with the market risk amendment and should be covered in any sensible interest rate risk management system. A major change in the operation of financial institutions lies in their perception of customers in two different ways, i.e. from a management perspective and from an information perspective. A retail institution in recruiting a customer or making a sale expects that other transactions and product purchases will derive from this. The customer relationship has value and this may be in addition to that created by the individual asset or liability impacts. Market risk amendment isolates the market risk in relation to interest rates in the mismatch units. The operations of the bank create the risks and the centre manages them. This may be a sensible relationship from the perspective of centralised risk management but it does have some important implications which are not entirely rational. The operational unit will ignore the market risk position of the bank in deciding whether to accept funding or to make a loan. It may by its operations reduce or raise the bank's levels of market risk and in terms of profitability and incentives these impacts will be entirely ignored.

CONCLUSIONS The different types of transfer pricing system used by financial organisations in relation to funds have been considered in this chapter, starting with the least sophisticated. Attention was then given to the more complex systems and these are seen as the basis for performance evaluation and isolating risk within a centralised function for management. This is an important issue where market risk management and the implementation of the market risk amendment are concerned.

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9 The transfer price of funds: some perspectives on wholesale and retail funding

INTRODUCTION In the previous chapter we considered the general theory of funds transfer pricing, which is certainly appropriate for the wholesale market environment. However, within the banking industry there is much debate as to whether it is entirely pertinent to the consideration of retail funding and lending. Retail business differs from wholesale in several ways and it is often argued that different transfer pricing considerations should apply to retail funds. This chapter also deals with discontinuities and the problems created for funding where there is a relationship between funding levels and credit ratings.

TO WHAT EXTENT ARE WHOLESALE AND RETAIL FUNDING EQUIVALENT? If the types of transfer prices described in the previous chapter are applied to retail funding obligations it appears that wholesale and retail funding obligations are perfect substitutes for each other. One perspective of finance postulates that firms should be run so that the outside markets provide a test for judging the internal activities of the business. If wholesale products are intrinsically different from retail products then these differences should be reflected in the use of any outside market judgements and in the setting of transfer prices. However, there are a number of differences between wholesale funding and retail funding and these distinctions will be discussed in the sections

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that follow. It will also be considered whether these differences merit dissimilar treatments from a transfer pricing perspective.

PRICE MAKING Institutions have the ability to set prices in most retail financial services markets, in essence this is selling in oligopolistic markets. There is only a small range of providers of retail financial services from which customers can choose and so suppliers set prices that are not entirely determined by the market. However, in wholesale markets, prices are determined by the market. An institution raises its funding on the wholesale markets over a certain time period and it may impact on the price that has to be paid for the funds; this may take place through changes in ratings. If an institution lends money there is no similar phenomenon. If money is borrowed there may be changes in the risks faced by providers of funds. In wholesale and retail markets increased funding requires higher rates. However, there are differences. In the wholesale markets increased funding means increased investor risk but in the retail market, while this is also the case, the institution has the ability to wield market power because it is only one of a limited number of institutions that can supply the products to any given customer. In retail banking markets, the pricing of retail balance sheet products illustrates a specific use of market power. Pricing is usually considered in terms of the overall balance sheet and is seen in the context of establishing an adequate net interest margin for the institution. The price on a particular product depends on the manipulation of pricing over a range of similar products. The pricing policy has often, in historical terms, been seen as related to the use of product development to exploit consumers' lack of responsiveness to new and more attractive products. If, for example, one wishes to raise funds one could raise interest rates on the current product range. Then all previous funds will benefit from higher rates and new funds will be attracted. If, however, one launches a new substitute product which only has the higher rate, not all the old customers will transfer their funds to the new product. Pricing decisions between similar products and product development can provide lower funding costs. The general level of interest rates for some banking institutions is set using a wholesale rate such as the three month LIBOR to price their variable rate products. The nature of the margins to LIBOR is dependent on the degree of wholesale funding in the balance sheet. If a bank has a high level of wholesale funding it tends to price as a mark-up from the wholesale market for asset products and a markdown for liability products. Where institutions have a high degree of retail as opposed to

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wholesale funding the relationship between retail prices and wholesale prices has been more variable. In some situations, the liability products are priced above wholesale rates at the bottom of the interest rate cycle and asset products priced below wholesale rates at the top of the interest rate cycle. Another pricing phenomenon seen within retail banks is that as they widen their margins for a short period as they change their rates. This is the case with variable rate products. Therefore, if interest rates are rising, asset rates rise before liability rates do and if interest rates are falling, liability rates decrease before asset rates fall. There are differences between wholesale funds and retail funds where pricing issues are considered. Should these differences be reflected in the generation of transfer prices in order to understand the value created for an organisation by retail as opposed to wholesale funding? If wholesale and retail funds are perfect substitutes in their uses for an organisation then prices attributed to them should be identical. In this case it is argued that discretions in pricing are valuable but this will only be the case if the prices paid on funding are lower than those required for wholesale funding. It is therefore likely that marginal prices will be wholesale and for most retail products there will be a margin made in relation to this transfer price. The discretion in pricing means that retail products can create more value and the marginal or wholesale price is the measure by which that extra value is judged.

EFFECTIVE DURATION OF FUNDS It is often argued within financial institutions that retail funds are `stickier' than wholesale funds. In the case of fixed term funds a customer in the retail market is less sensitive than a customer in the wholesale market. This means that when the term ends the funds are more likely to stay within a retail institution. The retail funding products which are available on demand provide funds for long periods of time as is the case with a standard transactions account. A related phenomenon occurs in a liquidity crisis for a banking institution here: retail funds have a lower probability of withdrawal and therefore are more valuable. These arguments are simply another facet to those on pricing. The `stickiness' makes it possible to gain from manipulating pricing and so its value lies in terms of a lower cost of funds rather than a lower test rate as provided by a transfer price. Where there is a run on a bank the issues are less easy to see from a pricing perspective and need to be considered separately. Can the benefits of the `stickiness' factor be seen to increase with a fall in a bank's credit rating? If a bank is in difficulties as regards liquidity will the differences between wholesale and retail have any value when the regulators are likely to intervene

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SOME PERSPECTIVES ON WHOLESALE AND RETAIL FUNDING

and change the status of the bank? These factors may need to be recognised when considering retail funding but in normal operations for healthy institutions its impact is likely to be negligible.

DIFFERENCES BETWEEN WHOLESALE AND RETAIL CUSTOMERS Customers of retail businesses have, over the past few years, become seen as the key generators of their value. It is generally believed that customer retention is a much more profitable marketing target than is customer recruitment because it is usually cheaper to retain than to attract. However, when applying these concepts to the retail financial services industry many reservations must be made. (Smullen 1998) For most banking institutions some 80% of retail customers are likely to be unprofitable and so a retail financial institution must understand clearly the behavioural and financial aspects of actual and potential customer relationships. The customers of retail financial services in terms of multi-product long-term relationships can be a valuable asset to retail funding. In deciding how important customer relations are to an organisation it may need to develop a system of transfer pricing which reflects their strategic significance. Some of these issues are dealt with in Chapter 16.

DISCONTINUITIES IN WHOLESALE FUNDING It may be impossible for a financial institution to raise funds above a certain level within a given time period without this leading to a deterioration of its credit rating. Some of the resulting issues can simply be dealt with in terms of a single time period model of a bank which raises funds and lends them for the same term and involving the same risk. These issues are considered in isolation with the assumption that they are the only activities of the financial institution. The model could be useful for the traditional Savings and Loan or Building Society, but the perspective would need to be accommodated if the institution's balance sheet is more complicated. The situation is depicted in Fig. 9.1. In part (b) of the figure the marginal cost of funding has a discontinuity at BS1 when its rating is lowered so the marginal costs of extra funding rises. The question as to what is a sensible balance sheet size can be understood in terms of the choice between two sizes of balance sheet. They are represented by the unit less than BS1 or at BS2; at both points the marginal costs of funds equals the marginal revenue of funding, the marginal cost of funding being represented by the highlighted black lines linking abcde. The choice as to which of the two balance sheet sizes should be chosen depends on whether the total profitability of the organisation declines with the change in the rating. The average funding rate

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Figure 9.1 The impact of rating changes on transfer prices. rises with the deterioration in the institution's rating. To ensure that decision making is not dysfunctional we must set up transfer prices to make certain that sensible gains are attributed to funding and lending and that sensible motivation will prevail if the lending and funding operations are separated. This means that the choice is between tp1 if BS1 is the value maximising position and tp2 if BS2 is the correct balance sheet size.

CONCLUSIONS There are some points that should be considered in establishing transfer prices for wholesale and retail funding and lending. If wholesale funding is to be the test for the effectiveness of retail funding then one should consider the extent to which the two are effective substitutes for each other. In general, it is rational to interchange them and therefore wholesale rates may provide sensible transfer pricing for both retail and wholesale activities. However, with respect to the `stickiness' of funds in a crisis and the possible issues in relation to customer value and profitability there may be benefits from retail funds that are not possessed by wholesale funds. Another difference between wholesale and retail funding lies in the possibility of re-rating and its impacts, since this may lead to discontinuities in the marginal and average cost of funds.

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10 The transfer pricing of capital

INTRODUCTION The term `capital' is used in a number of different senses within business and especially within financial institutions. In businesses generally, it is a term which refers to the long-term funding of the organisation and is divided into debt and equity. Within financial organisations raising debt is often a vital business activity and is the key input into the activities of lending and investment. However, for financial institutions the term capital tends to be used for equity or near-equity funding rather than for debt and equity generally. There is also a sense in which equity capital is vital to all business organisations as a buffer against financial difficulty. Increasing the level of debt is seen to increase the risks of the business. The idea of capital as a buffer to losses provided by risk-taking funders is now considered a key perspective for the finance industry where capital may be defined in a way that is regulatory specific. Since the financial services industry is vital to the running of a market economy it is subject to regulation that decreases its susceptibility to shocks which may lead to financial crises. The level of capital will determine the ability of an institution to overcome shocks created by its operation and therefore is an essential part of regulation. Capital can therefore be seen both as a funding mechanism and as a buffer against default. The concept of a buffer against default is an essential tenet within the finance industry and has a vital regulatory role. A number of different types of transfer price are used to allocate capital to different activities, determined by the perception of the role of capital. Because capital is the buffer against default and loss by non-equity (or close to equity) funders it should be allocated to any activity which is subject to a degree of risk of default or loss. There are regulations which govern the capital a financial institution needs to undertake its operations and these capital requirements are related to specific levels of risk activity. It is thus possible to allocate such capital to those activities.

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These three different types of capital allocation: for funding, for regulation and for risk management are related but are not necessarily the same. This chapter will discuss these capital allocations in detail and then evaluate critically their usefulness.

CAPITAL AS FUNDING The choice of the optimal level of debt and equity in any business is a matter for debate. The initial starting point has, over the past few decades, been that of Modigliani and Millar (1958), who argued that in perfect capital markets a business should be indifferent in terms of its overall value and funding cost as to its level of debt and equity funding. This insight has been subject to a number of qualifications which give greater understanding of the real world, in particular that taxation advantages may be obtained by debt funding, that there are costs associated with the increased possibility of default with higher levels of debt funding, and that businesses with high levels of gearing may be better managed. There are other factors which enter into the ability of the firm to gear up including the marketability of tangible assets which they own and their break up values. These are strongly related to the degree to which a business owes its success to intangibles such as reputation, branding and customer relations. Within the financial sector there are additional considerations. (Merton 1977; Sharpe 1978; Buser, Chen and Kane 1981) Financial institutions differ from others in terms of possible failure; because of their key role within the economy they may not be allowed to fail and investors will be protected by the regulatory authorities. Also, in banking, there is likely to be the provision of deposit insurance. Thus there may be benefits from enhanced gearing. If a retail financial institution raises funding from its retail base it is possible that this will be on terms and conditions which are favourable to those which operate on the financial markets. If this is the case there is another reason for raising the levels of debt funding at the expense of equity funding. Therefore, there are a number of reasons why financial institutions should have a high level of gearing. They are subject to all the factors encountered by non-financial institutions to benefit from, as for example, the tax shields in relation to debt funding. They also may benefit from their position in relation to the regulation of the economy leading to protection for their debt holders. Since raising finance from retail markets may provide funding at lower costs than those encountered in the financial markets there is an extra reason for raising debt.

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THE TRANSFER PRICING OF CAPITAL

One key role for funding costs relates to capital appraisal and decision appraisal within a business. In a non-financial enterprise the standard appraisal procedure is to identify the timing and magnitude of the marginal cashflows and to estimate the present value of the decision. There are a number of procedures which can be used to undertake this exercise but the simplest and most sensible is to use a technique referred to as adjusted present value. The after-tax decisions cashflows should be discounted by the rate of return if the project is equity funded. The risk of the project should be evaluated and the appropriate equity rate of return calculated, which is the appropriate discount rate. If there are any benefits from funding, for example tax shields which allow debt funding for the project to lower its costs, the value of these benefits should be calculated separately. The project should always be viewed as marginal to the activities of the business.

In order to see how this might apply to the finance industry let us consider the example of a bank which wishes to set up an e-commerce savings operation, that for simplicity's sake only offers fiveyear fixed rate bonds to retail-savings customers. The bond offers a rate of interest which has a margin of 50 basis points below the appropriate wholesale market rate. There are up front running costs for the business unit.

The cashflow that must be specified by a transfer price is that in relation to revenue and so we need some hypothesis regarding the usage of the funding raised by the product. As already stated in Chapter 8 the five-year funding will be matched by a transfer price of five-year money on the financial markets. This implies that the inflow of funds for the retail product is matched by an outflow of lending and when the five-year product is redeemed then a matching cashflow payment is regarded as a capital repayment in relation to the transfer price. In other words the investment flows into and out of the five-year product at redemption are matched by notional flow. These flows net out and what is left is the interest rate margin of 50 basis points in our example. In essence it is a hypothetical exchange.

Other cashflows that relate to any capital expenditure and operating expenses need to be discounted as will the cashflows of the hypothetical exchange, and the procedure to be adopted in the case of these cashflows must be determined. We have already considered the impacts of the five-year funding on any tax-related benefits since these will form part of the evaluation of the post-tax cashflows. The cashflows identified will have a certain level of risk associated with them and they should be considered in terms of a present value in relation to the equity return of identical risk. If there are

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TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

other funding implications for the project which lead to the exploitation of tax shields then these should be included at their current value that takes place at the rate of interest required for that type of debt on the capital market. In the above example a bank has been considered to resemble any other business except that its function is lending and borrowing money and the role of capital (including equity capital) is to provide funding. In the financial industry there is an alternative view of capital: it is seen as a buffer against default to non-capital funders. For this reason there are regulatory requirements which govern funding and the requirement of capital to back certain levels of risk. In the example of the e-commerce savings business discussed above many of the problems that regard capital as a buffer against losses were avoided. The business may make losses, that is obvious, in that its capital expenditure and operating expenses may be such that the business is unsuccessful. However, the focus on losses in relation to capital in the finance industry has concerned the investment of funds, not the levels of expenses relative to revenues. A different example would be that of an e-commerce mortgage lender and in this environment a capital allocation will more probably be employed in common banking practice. If a bank sells mortgages there is a capital allocation from a regulatory perspective to cover the risks involved in the mortgage lending. This allocation could be factored into the calculation by making the funding for the mortgages partly matched in term and risk by a funds transfer price and be partly funded by capital with a required level of return on the capital. Capital could, in principle, be allocated to the mortgages in relation to the capital at risk (CAR) because of the probability of losses on the mortgages offered. This technique and its implications are discussed in this chapter and in the chapter on return on risk adjusted capital (RORAC). With asset products there may be allocations of capital relating to risk and these modifications are often used to alter slightly the present value calculation. The next two sections consider regulatory capital and capital at risk.

REGULATORY CAPITAL The regulators of the financial industry have focused on ensuring that institutions have capital to absorb losses, as protection for non-equity providers of funds. These regulations have received their most comprehensive treatment by virtue of the capital requirements of the Bank for International Settlements and their application to the banking industry world-wide. The focus of this chapter will be on their variant of regulation. A bank is required to hold a certain amount of capital as a minimum.

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THE TRANSFER PRICING OF CAPITAL

What implications should this have for the bank's activity? A bank will ensure that in all normal circumstances it will have capital which justifies its enterprise and will have a constraint on its activity to ensure it keeps within the boundaries that have been set. The constraint will be more onerous than that required by regulation since variations in activity that the bank does not entirely control need to be accommodated. It is widely recognised that the regulatory constraint does not reflect the actual risk involved in a bank's activity. The initial Basle regulations on credit risk could not be justified in terms of the underlying risks of the different assets and even more recent developments have been criticised on similar grounds. The Credit Risk Amendment, however, does allow banks to generate capital requirements in terms of their internal risk analysis. The issue considered here is what the transfer pricing behaviour should be in relation to these regulatory constraints, rather than whether the risks identified and underlying the regulatory capital are sensible. In the case of a bank whose objective is to maximise shareholder value and that procedure is undertaken by maximising present value it is necessary to consider how it should behave in relation to the regulatory constraint. Some of the key ideas are illustrated in Fig. 10.1. The diagrams illustrate the value maximisation problem of a bank in terms of a one period value maximisation theory of the firm. Here the bank simply raises retail funds and lends them retail. Issues in relation to interest, credit and exchange rate risk are ignored as they can be seen in terms of matching funding and lending and prices are then adjusted for credit risk in relation to lending. The price is understood in terms of a rate of interest and the quantity bought and sold is measured in terms of the value of asset and liability. The D curve on the diagrams gives the demand for the lending product and the S curve is the supply curve for the liability product. The MR curves show the marginal revenue from the lending product, the MC the marginal cost of funding and the K curve the regulatory constraint.

Figure 10.1 The impacts of capital regulation.

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TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

Given the asset and activity composition there will be a required level of capital. The actual level of capital will, in all likelihood, exceed this level and it could be returned to the shareholders if it is not generating sufficient returns. The prices are seen in terms of interest rates and the quantities in terms of the balance sheet size of the bank. In diagram (a) the constraint is not binding and has no impact on the choice of the optimal level of business. The efficient transfer price is RT, the asset and liability turns being Ra ± RT and RT ± Rl respectively. In deciding the value-maximising solution the constraint is immaterial since it is not binding. In (b) the constraint holds and the situation is entirely different. The value-maximising level for the balance sheet is defined by K. The prices and returns to the different activities can be characterised as follows: Ra ± RaT is the return on the asset product, RlT ± Rl is the return on the liability product, and RaT ± RlT is the return to the constraint. This analysis appears to have a number of important conclusions that determine what a bank should do regarding the capital constraint which limits the possible size of the balance sheet. The first and most obvious conclusion is that the constraint has no impact for optimal decision making when it is not binding. Where it is binding then there is an optimal charge in relation to the constraint and the value of this charge depends on the degree to which the constraint is binding as shown in Fig. 10.2. The more binding constraint K2 has a higher optimal charge (A ± D) than has the less binding constraint K1 whose charge is B ± C. It is the individual institution which determines the relevance of the level of constraints and the transfer price in relation to the capital constraint. The organisation can change the level of the constraints and this has considerable bearing on the question under discussion. If the return to the constraint is higher than the market rate at which capital can be raised then there is an incentive to raise extra capital. If there is no capital constraint then it should be considered whether the business should lower its capital until the constraint is binding.

Figure 10.2 The impacts of different levels of constraints.

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THE TRANSFER PRICING OF CAPITAL

The difference between capital as defined by the Basle-based regulations and the way in which the term capital is used in relation to the theory of finance can be debated yet further. In the Basle regulations the definition of capital is stated in terms of the financial accounts and different measures on the balance sheet but the capital which lies at the core of finance theory is related to the market value of debt and equity. The market value of equity and the balance sheet value of equity may have little in common.

CAPITAL AT RISK Capital at risk (CAR) is an internal modelling perspective on the definition of capital and its allocation to specific activities. The technique considers a given activity and asks how much capital is at risk in terms of a vision of worst case outcome. The basic principle is illustrated in Fig. 10.3 in relation to what might, for example, be a credit risk. The distribution of losses with regard to credit risk, for a particular time period, is likely to be skewed to the right which means that the average loss 0x will be to the right of the modal level for the losses of the distribution. The average losses may be part of the pricing decision for the organisation. There will be a time period when losses exceed the average and these will be the periods when the capital of the organisation will be required to cover the levels of loss in excess of the average. The capital at risk gives precise meaning to what is often rather vaguely expressed as the worst case scenario. An exact definition of capital at risk states that it is the level of losses above the average which will only be exceeded in a given percentage (a) of the time periods. In Fig. 10.3 it will be measured by the distance y ± x. It is a specific usage of the concept of Value at Risk from which it is derived. The allocation of capital at risk can thus be attempted for all those activities which can be effectively modelled for risk.

Figure 10.3 Capital at risk.

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A number of other issues must be dealt with in order to formalise a system of capital at risk modelling. The value of a must be decided. The most usual way of doing this within the banking industry is by deciding on a desired credit rating and applying the default rate associated with that rating. Having determined a we can then decide on the level of capital which should be allocated to a particular activity. The time period of the analysis must also be specified and this may vary with the activity under consideration. A ten-day period may be appropriate for market risk and a longer period, perhaps a year, might be found appropriate for operational and credit risks. After capital has been allocated the required return in relation to that capital must be discussed. These issues are dealt with in more detail in Chapter 12 which looks at return on risk adjusted capital (RORAC). However, it is pertinent here to make some general comments on the methodology. Return on capital may be associated with the regulatory capital if the bank applies, for example, the market risk amendment where the capital allocated to market risk is determined by CAR methodology (although in this chapter we have illustrated the concepts in terms of credit rather than in terms of market risk). The comments about the nature of regulatory capital are identical with those in the section on regulatory capital above. Alternatively, return on capital may not be seen as regulatory capital and then one should consider what is actually happening in this instance. This role for capital is not a funding role and the issue of allocating capital for funding purposes is entirely different as was discussed earlier in this chapter. The capital can be likened to a reserve or insurance which is held in case of certain worst case scenarios and its influence on decision making can only be considered if a price is levied. These issues are raised and discussed in the section on RORAC.

CONCLUSIONS The role of capital in financial institutions is as a means of funding and as a buffer against losses to certain suppliers of funds. There are a number of reasons why financial institutions should be very highly geared including their regulatory environment and their competitive advantage in the raising and disposing of funds. The term capital is used in a number of ways: as defined by regulators, as specified by financial accounting definitions and classifications, and in terms of the equity value of the business. Capital allocations serve a number of functions. Firstly as part of the funding mix, secondly in the justification of certain activities through regulations on the level of capital and thirdly as part of a system to reflect adequately the risks to the enterprise of certain activities. Underlying the different perspectives and uses for capital is a lack of consistency in attitudes to risk and shareholder value.

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11 Risk adjusted performance measures: the transfer price of investment portfolios

INTRODUCTION All financial institutions hold portfolios of financial obligations and the performance of these portfolios must be judged by transfer pricing systems. These systems evaluate portfolios in terms of the returns and risk embodied within the portfolio. The initial starting point for the construction of risk adjusted performance measures (RAPMs) lies in Portfolio Theory. This theory describes normally distributed returns on assets and indicates that investments should be judged in terms of the average return and the standard deviation or variance of those returns. If distributions of returns are normal then these two measures will define the properties of the distribution exactly and totally. Risk as measured by the standard deviation of returns is extremely important. When the transfer prices for funds were considered, whether they were assets or liabilities, there was a matching of term and risk. Under Portfolio Theory, the returns of assets are not perfectly correlated so that some risks may be hedged by an investor holding a number of assets. The performance of a portfolio should not be judged by its return alone and its return should be adjusted for its risk. The theory of portfolio evaluation is to some extent at variance with the traditional theory of financial markets. Market efficiency has been one of the core propositions of modern finance and argues that exceptional returns cannot, on average, be obtained on the basis of the information available to the market. Fama (see Fama 1970) outlined three types of market efficiency based on

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different levels of information available in the market and incorporated into market prices: they are described as follows. In weak form efficiency there is no advantage based on information relating to past market prices. In semi-strong form efficiency all the information in the public domain is incorporated in current prices so no advantage can be gained from that information. In strong form efficiency all information, public or private, is incorporated into prices. Most finance experts believe that the markets are either weak or semi-strong. The concept of efficient markets excludes the underor over-valuation of assets. If these markets are judged to be efficient then any difference in returns from an individual portfolio can only be the result of taking greater risk, or of random processes or where possible of superior information to the market. Some might argue that institutional investors are capable of obtaining exceptional returns due to their greater knowledge of factors which influence prices. Many institutional investors spend large amounts of money in order to increase the return on their investment portfolio. The impacts are discussed in terms of modelling information efficient equilibria. (Grossman and Stiglitz 1980) Many tests have been carried out by financial economists to determine whether institutional investors generate abnormal returns when transaction costs and risks are taken into consideration. Numerous studies indicate that such investors do not get better results than others although they may be able to justify expenditure on market-related research. However, these theories where investors gain superior knowledge through research and where markets are in a state of equilibrium do not show that institutional investors enjoy abnormal advantages in terms of rates of return. Consider two groups of investors: those who seek out extra information and those who refrain from this activity. Neither group obtains abnormal returns since if one group were able to obtain extra returns then investors would switch between categories and ultimately these extra returns would be eliminated. In recent years there has been an increasing number of academic studies which have expressed unease with the concept of efficient markets and there are apparent empirical anomalies in financial markets. The difficulty is that any data series will have some apparent regularities even if it is random, provided enough data mining is undertaken on the numbers. Of all economic hypotheses the efficient market hypothesis is possibly the one which has been most thoroughly tested. Deciding what are significant anomalies requires not only identifying the past policies which might have led to abnormal returns but ensuring that investing on those anomalies leads to above average returns in the future.

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Practitioners have been more sanguine about the possibility of obtaining abnormal returns in relation to the market and their activities show some scepticism towards the idea of efficient markets. Technical forecasting has shown some success in generating abnormal returns which is based on a short-term psychologically justified analysis of market trends. RAPMs can be viewed as ex-ante and ex-post measures of performance. On the basis of past data ex-ante measures can be used to predict future performance and hence motivate future investment, based on the proposition that the regularities revealed in the past will represent future return behaviour. Ex-post RAPMs can also be used to measure past performance. It is important to state that their use is based on a belief that markets are not efficient. It is an interesting irony that Treynor and Jensen developed their measures to test the validity of the efficient market hypothesis and indeed their studies provided support for the hypothesis. We shall consider a number of measures of portfolio performance; the Treynor measure, Jensen's alpha, the Sharpe ratio and the Treynor Black ratio.

GENERAL ISSUES IN RELATION TO RAPMs There are a number of interesting issues raised by RAPMs that may not be considered adequately within the finance industry. RAPMs are approximations of investors' utility functions and may, as a result, not entirely reflect the shareholders' exact wishes. In Chapter 6 we considered attitudes to risk and discussed alternatives to traditional standard deviation measures of risk in relation to worst case based measures of risk and the time perspective with which investors view their investments. These issues may provide criticisms of more traditional RAPMs and provide a basis for the development of new and different RAPMs in the future. RAPMs are also of their very nature statistics and therefore any application to practical situations should reflect their probabilistic nature. One issue raised by the use of RAPMs is their assumptions about the motivations of investors in that they are based on the view that investors are interested in returns and risk measured by a number of different perspectives. Portfolio Theory and the capital asset pricing model (CAPM) are based on the proposition that investors are risk averse and see higher returns as good and greater risk as measured by the standard deviation of returns as bad. The RAPMs involve more stringent assumptions about investor attitudes to risk and return, which are less intuitively sensible than the simple proposition that investors are risk averse. The concept of Value at Risk has become part of finance theory in recent years. One of its rational aspects is that investors may be interested in the unfavourable end of the distribution of returns and

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these risks may not be adequately captured by the variance or standard deviation of returns and the concept therefore helps us move away from the empirically false proposition that returns are normally distributed. We will discuss RAPMs based on Value at Risk in the context of transfer prices for capital, with regard to RORAC in Chapter 12. The time dimension of investment in shares, bonds and money-market instruments is an area for possible development where the desires of investors are concerned. In the short-term the least risky are money market instruments and shares the most risky. This order is not necessarily the case if returns are made over a longer perspective. Relevant factors are explored in more detail in Chapter 6 and, in particular, in Table 6.1. Within the market the rates of return reflect the short-term order and so it seems likely that investors are generally orientated towards short-term gains. However, this is not the case for all investors and it may be that those with a longer term perspective should use RAPMs which reflect their time perspective. It is also important to realise that the RAPMs are statistics. Estimations of the average return and the measure of risk involve estimations of a statistic. The RAPM will involve a combination of these two measures and therefore can only be understood as an estimate of the correct value for a particular RAPM. The distribution of the RAPM needs to be considered as does hypothesis testing if a sensible view is to be adopted for the use of RAPMs.

THE MEASURES The following paragraphs outline the most common RAPMs used for investment portfolio evaluation and present a critical evaluation of their individual merits. The RAPMs that have developed in relation to capital allocation and the concept of Value at Risk are considered specifically in a later chapter but the general comments on RAPMs can be applied to them as readily as to the portfolio measures considered in this section.

The Treynor measure The Treynor measure is extracted directly from the CAPM which suggests that the required or expected return on an asset or portfolio of assets is given by equation 11.1.

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E(Rp) = Rf + bp(Rm ± Rf) Rm ± Rf = Tp =

where :

E(Rp) ± Rf

[11.1] [11.2]

bp

Rp ± Rf

[11.3]

bp

E(Rp)

= Expected or required return on portfolio being considered

Rf

= The risk free rate of return

Rm

= Return on the market

bp

= The beta of the portfolio being considered

Tp

= The Treynor measure of the portfolio

If Tp > Rm ± Rf = > Rp > E(Rp)

[11.4]

Equations 11.2 and 11.3 give the derivation of the Treynor measure, and equation 11.4 indicates how it can be a measure of performance. If Rp is greater than E(Rp), over any given period of time, this may just be the result of the stochastic nature of Rp and is not necessarily an indication of superior performance. It will be possible to develop statistical tests for Tp but the clarity of the measure will undoubtedly be blurred by doing this. Perhaps the most interesting aspect of these types of performance measures and their limitations relates to the preference structures which underlie their use. This is illustrated in Fig. 11.1. Equation 11.3. can be reorganised to give equation 11.5. Rp = Rf + Tpbp

[11.5]

If Tp takes a fixed value then 11.5 is the equation of a straight line, and varying Tp will lead to a set of straight lines, two of which are illustrated in Fig. 11.1. The Treynor measure criterion for ranking portfolios is that if Tp2 > Tp1 then portfolio 2 has superior performance to portfolio 1. The line marked Tp2 in Fig. 11.1 is steeper than that marked Tp1 so it has a higher Treynor measure. Therefore by the Treynor criterion, portfolio 2 is preferred to portfolio 1. However, the decision between the two portfolios is less clear if we simply ask a risk averse investor, defined here in terms of b rather than by the standard deviation, to choose between portfolio 1 and portfolio 2. The decision cannot be made if one simply specifies the investor's preferences as being risk averse. Portfolio 1 has

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Figure 11.1 The utility-related problems of Treynor measures.

higher returns and greater risk than portfolio 2. This example illustrates that the Treynor measure will be more appropriate for investors who are more risk averse and if investors are less risk averse this criterion may make the wrong decisions in portfolio evaluation.

Jensen's alpha Jensen's alpha (ap) is also derived from the CAPM. Its derivation is illustrated in equations 11.6, 11.7 and 11.8. The higher its value the better the portfolio. E(Rp) = Rf + bp(Rm ± Rf)

[11.6]

0 = E(Rp) ± Rf ± bp(Rm ± Rf)

[11.7]

ap = Rp ± Rf ± bp(Rm ± Rf)

[11.8]

Rp = ap + Rf + bp(Rm ± Rf)

[11.9]

The argument discussed in the case of the Treynor ratio and preferences can be repeated with regard to the Jensen index. It is illustrated in Fig. 11.2 which is based on equation 11.9. The investment criterion states that the higher the Jensen index the better the portfolio performance. In this case also, it is based on preferences which are restrictive to risk averse investors again defined in term of b rather than by the standard deviation of returns. Once more it favours preferences which are particularly risk averse, since portfolio 2 is considered superior to portfolio 1 although it has lower returns and lower risk.

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THE TRANSFER PRICE OF INVESTMENT PORTFOLIOS

Figure 11.2 Utility problems with Jensen's alpha.

Figure 11.3 An illustration of anomalies between the Treynor and the Jensen measures.

It is an interesting question as to whether the Treynor measure and the Jensen measure give the same ordering of portfolios. In fact, although they share several limitations, they give a different ordering. This is illustrated in Fig. 11.3. Portfolio 1 which has a return/risk combination of (Rp1,bp1) is preferred to portfolio 2 which has a return/risk combination of (Rp2,bp2) in terms of Jensen's alpha, but is considered inferior if the criterion is the Treynor measure. The Jensen measure implies a greater tolerance to risk than that implied by the Treynor measure.

The Sharpe ratio The third portfolio measure is the Sharpe ratio which is defined numerically in equation 11.10 and a common specification of it is given in equation 11.11 where the risk-free portfolio has been used as

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the benchmark. Since it focuses on the standard deviation of the returns of the portfolio under consideration and the benchmark portfolio it does not benefit from the covariance properties associated with measures based on the

S=

where :

S=

where :

Rp ± Rb d = sd sd

S

= The Sharpe ratio

Rp

= Returns on the portfolio being evaluated

Rb

= Returns on the benchmark portfolio

sd

= The standard deviation of (Rp ± Rb)

d

= Rp ± Rb

Rp ± Rf sp

[11.10]

[11.11]

Rf = Risk free rate of return sp = The standard deviation of returns on the portfolio

CAPM considered above. This is illustrated by considering the decision to add assets to a portfolio. This should not be done by considering the new investment and choosing that with the highest Sharpe ratio since this will not incorporate the impacts on the variance of the new total portfolio containing previous investments. The method for choosing should be to consider the old portfolio and compare its Sharpe ratio with the ratio for the whole new proposed portfolio including old investments. There are some merits in doing this because if the CAPM based measures assume that the institution concerned has invested in the market portfolio they will not be entirely sensible. However, institutions do not invest in the whole portfolio of assets and this `Incremental Sharpe ratio' approach considers the actual rather than the theoretical portfolio of investments. Some authors, notably Dowd (1998) strongly, favour the measure for this reason. Applications of the Sharpe ratio are shown in Fig. 11.4. It, like other RAPMs, makes implicit assumptions about the preferences of investors where it is used to evaluate investment or portfolio performance. This is illustrated by equation 11.12 which is derived from equation 11.11. Rp = Rf + Ssp

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[11.12]

THE TRANSFER PRICE OF INVESTMENT PORTFOLIOS

Figure 11.4 Applications of the Sharpe ratio.

It indicates that, as with the other ratios, there is an assumption of restricted risk aversion since portfolio 1 will be judged superior to portfolio 2 in terms of the Sharpe ratio. In this case the definition of risk aversion is that which is used in Portfolio Theory.

The Treynor-Black ratio The Treynor-Black ratio is the square of the Sharpe ratio. It suffers from the defect that if two portfolios have the same Sharpe ratio but opposite signs they are considered equally successful and the consequent ordering of portfolios is not sensible. Consider two portfolios that have the same sd. While one is superior to the benchmark portfolio in terms of its returns and the other inferior, they will have the same Treynor-Black score and therefore be considered equally desirable. The ratio suffers from all the other problems associated with the Sharpe ratio. Using a risk-free portfolio as the benchmark the nature of the Treynor-Black ratio can be understood from equations 11.13 and 11.14. The implicit utility function is depicted in Fig. 11.5. The ordering for portfolios with returns greater than the benchmark will be identical to that in the case of the Sharpe ratio although the metric will be its square. TB2 is preferred to TB1. 2

TB =

Rp ± Rf sp

Rp = Rf + H(TB)sp

[11.13]

[11.14]

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Figure 11.5 The Treynor-Black ratio.

PROBLEMS WITH THE MEASURES There are serious problems with all these ratios. Firstly, although developed in some cases to test the veracity of the CAPM and the efficient market hypothesis, they assume that markets are not efficient if they are used to measure the success of portfolios. Secondly, they try to combine two measures, return and risk, in a single measure that will set restrictions. They impose certain investor preferences on the evaluation judgement which have neither logical nor empirical support. Thirdly, it is not obvious that the return/risk paradigm which is central to certain vital tenets in the theory of finance is sufficient to describe investor preferences. The ease of using normal distributions ignores the issue of risks and their relationship to abnormal distributions of investor returns. The abnormality is evidenced by the many observations in the tails of the distribution. In view of all these factors these ratios are not very useful in portfolio evaluation. The more recent trends to tracker funds and relating portfolio investment performance and evaluation to the preferences of investors seem more in line with finance theory and the arguments made above. Any portfolio performance measure is a statistic. Whatever the definition of return or risk these measures are drawn from a distribution. Any particular return and any estimate of risk are instances taken from a distribution of possible returns. Using one of the measures described above to evaluate whether performance is better than a benchmark, or than the market, or than another portfolio is in essence a statistical test and in general the measures have not been used within the context of statistical testing.

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CONCLUSIONS The evaluation of portfolios by the measures described above is derived from the risk measures that are related to Portfolio Theory and the CAPM. An additional factor is that most institutional investors when they account for transaction costs only make an abnormal return by chance and the use of the indicators therefore is a statistical test. The application of portfolio measures of return is far from simple and the conclusions to be drawn far from obvious.

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12 Risk adjusted performance measures: return on risk adjusted capital and associated measures

INTRODUCTION There are a number of different measures which are used to describe capital and its relation with risk and return. The most commonly used is return on risk adjusted capital (RORAC) which is used as a widespread measure of performance in the finance and banking world. This chapter outlines the fundamental technique and attempts to illustrate its weaknesses as a basis for any formal evaluation system.

RORAC The initial step in the estimation of the RORAC of an activity is to allocate capital to that activity. The capital allocated could be regulatory but does not need to be so and is more usually capital at risk (CAR). (See Chapter 10 and Bressis (1998).) The argument for using CAR rather than regulatory capital is that the latter does not in general reflect the actual risk of the specific activity. Regulatory capital requirements constitute a constraint of a general nature. The estimation of CAR is illustrated in Figs. 12.1 and 12.2 which depict the application in relation to credit risk.

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RETURN ON RISK ADJUSTED CAPITAL AND ASSOCIATED MEASURES

Figure 12.1 The calculation of capital at risk (CAR) for credit risk.

For example, Fig. 12.1 reflects losses in relation to the credit risk of an activity. The distribution shows the losses obtained on a portfolio of loans over a given time period. The distribution is skewed to the right because there will be years of relatively heavy losses and cannot be exactly characterised by the mean and standard deviation. E(L) is the average level of losses over a number of years and is probably covered in the pricing of the lending institution. The CAR is defined in equation 12.1 and is the difference between the Value at Risk (VAR) level of losses and the expected or average levels of losses E(L). CAR = VAR(L) ± E(L)

[12.1]

The relationship between capital at risk and market risk is illustrated in Fig. 12.2. The distribution of returns centres around an average return which will almost certainly be positive and the capital at risk will be based on the levels of loss obtained at a certain level of confidence. In the case of credit risk the time period considered is usually a year while the time period for market risk has in general been much shorter. Initial calculations focused on estimating a VAR on a daily basis but the regulations embodied in the market risk amendment have set the time period at ten days.

Figure 12.2 Capital at risk (CAR) for market risk.

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In the case of market risk the capital at risk is defined as the losses incurred at the Value at Risk and is given in equation 12.2. CAR = 0 ± VAR(R)

[12.2]

The VAR level of losses is seen to be the level of losses for which the institution holds capital; capital acts as a buffer against abnormal losses and protects the institution and certain categories of its funders, for example, depositors in banks. The VAR level of losses is the level that will be exceeded in a% of cases and a is determined by the desired default probability of the institution. This in turn is often decided on the basis of a desired credit rating and is the default probability associated with that rating. Having allocated capital or CAR to an activity the RORAC is calculated on the basis of equation 12.3.

RORAC =

Return CAR

[12.3]

The RORAC is therefore a ratio of the relevant return divided by a measure of risk and is, in essence, another measure of risk adjusted returns. The use of the measure differs between institutions but activities are usually ranked by RORAC. Institutions emphasise that only those activities with a sufficient RORAC are undertaken and the RORAC of activities is improved. The use of RORAC as a hurdle involves a specification of some targeted level of overall institutional returns.

EVALUATION OF RORAC STYLE MEASURES There are a number of important comments which should be made about the nature of RORAC measures and their applicability. Despite the fact they are widely used their limitations are not widely understood and this means that they are too easily misapplied. Their impacts can in fact be dysfunctional within organisations. As with all other risk-adjusted performance measures they are an implicit risk/return utility function and this function is depicted in Fig. 12.3. Each level of utility is represented by a straight line from the origin and is a given measure for RORAC. Thus U(2) represents a higher level of utility for the

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RETURN ON RISK ADJUSTED CAPITAL AND ASSOCIATED MEASURES

Figure 12.3 RAROC as an implicit utility function.

organisation than U(1) and is related to a higher measure for RORAC. The equation for each line can be deduced from equation 12.3. The relationship between risk and return is linear for a given level of RORAC and is illustrated in equation 12.4. Return = RORAC 6 CAR

[12.4]

There are a number of important implications for this implicit utility function. The first and widely understood implication is that the riskless activity will always have the highest RORAC. (Dowd 1998) If activities tend towards the riskless and towards requiring no capital then the RORAC tends towards the infinite. If the investments are riskless the implicit utility function involving lines from the origin is definitely flawed as a measure reflecting sensible organisational preferences. Firstly, here the riskless return is ranked as infinitely preferable and the organisation's shareholders are unlikely to follow this ranking. Secondly, if the utility function is of its very nature linear, this is a restriction on preferences. It is difficult to judge how important this restriction is. The third implication is that the implicit utility function may be highly risk averse and this leads to two important arguments. The specification of the VAR(L) involves the targeting of a certain credit rating. The credit rating targeted may be, and often is, better than the financial institution's current rating. To what extent can the desires of shareholders be interpreted as wanting a change in the credit rating? If financial markets are efficient, increased risk should be compensated by enhanced returns. The nature of the utility function indicates an odd relationship between risk and return that is illustrated in Fig. 12.4. It indicates an interesting type of risk aversion where the higher the return obtained for a given level of risk the more risk averse the institution appears to be. The deduction is in terms of returns and CAR rather than in terms of returns and standard deviations of returns which are usually the risk and return measures

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TRANSFER PRICING FOR FINANCIAL INSTITUTIONS

Figure 12.4 Utility peculiarities with RORAC.

used to define risk aversion. Compare points A and B where A and B have the same CAR but A has the higher returns. These are derived from two different levels of RORAC, 1 and 2 of which 2 is preferred. The trade-off between risk and return is given by the straight line representing the level of RORAC. In the case of RORAC2 it is steeper than RORAC1 so represents a higher degree of risk aversion. More return has to be obtained to compensate for an extra increment of risk. Why the degree of risk aversion should increase with returns is not obvious and quite possibly does not give a plausible picture of shareholders' views. The use of RORAC implicitly imposes this view of utility that seems to have no sensible justification. Risk Adjusted Performance Measures when applied to the evaluation of performance are seen as statistics. The return is a draw from a distribution of possible returns and the CAR is estimated on the basis of an established procedure. So how is it best to deal with the use of RORAC for performance measurement? There is the possibility of measurement error in any estimation of a particular RORAC as is illustrated in Fig. 12.5. The diagram shows the curves for two different investments A and B. The estimation of their returns and CAR is subject to estimation error. The distributions of the two RORAC statistics are given by A and B. In general, A is a better investment than B in terms of RORAC. However, in a particular time period it may be that the measures indicated by a and b reverse the order that is simply the working out of a random process. The ranking of A and B will always be problematic and can only be done on the basis of a statistical test. A hypothesis will only be held with a certain degree of confidence and the measures must always be used in relation to statistical testing or they will be unfounded.

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RETURN ON RISK ADJUSTED CAPITAL AND ASSOCIATED MEASURES

Figure 12.5 The distribution of RORAC.

One of the most important properties of any risk analysis is the fact that returns will have correlations which will most probably be less than one and so the construction of portfolios of activities confers beneficial impacts on risk. The RORAC defined in the opening sections of this chapter does not reflect this judgement. If an activity has a major hedging impact on the whole portfolio of activities it is more valuable than indicated by a stand-alone RORAC. It is possible to construct marginal RORACs by considering the impact of this activity on the overall risk/return combinations of the institution but the computations may not be easy. RORAC without this perspective may lead to incorrect judgements. Another aspect of RORAC may be problematic, depending on its precise implementation. RORAC despite the sophistication of its calculation resembles many accounting measures in that it is an average return in relation to a particular activity. In this case the activity is measured in terms of risk. Average measures, taken on their own and without consideration of other factors, may lead to incorrect decisions because it is marginal impacts that determine whether an activity is worthwhile or not. A better measure of the validity of an activity is to impute a necessary return to CAR (assuming CAR to be a useful concept) and then to deduct this capital charge from the net revenues of the activity. This might prove a more sensible marginal-based measure as stated in equation 12.5 where RCAR is the required return on CAR. Value Created by an Activity = Net revenue ± RCAR 6 CAR

[12.5]

In establishing a system of RORAC one has to define the levels of probability underlying the estimate of the CAR. This is usually done in terms of deciding on the desirable credit rating for the banking institution. It is not obvious why shareholders should be interested in the credit rating. If the credit rating of an institution is improved it will certainly benefit existing debt holders and if this

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lowers the risk of the organisation it may lower the required return on equity. The reasons why it should raise the value of the firm and benefit shareholders are far from clear.

IS THE RORAC APPROACH TOTALLY MISPLACED? If the central objective of a financial organisation is to maximise shareholder value would this lead it to set up a system based on RORAC? Let us consider the ways in which an organisation might set up a measurement system to maximise shareholder value and then see how this relates to the concept of RORAC. The two key internal techniques that help an organisation maximise its shareholder value are related to the concepts of present value and the diversity of techniques associated with economic value. These techniques can be summarised broadly in the following terms. Present value is the forecast of the future cashflows of the organisation discounted with a rate of discount that represents the capital market's evaluation of the risk associated with those cashflows. Economic value is a technique which can be applied to the current or expected cashflows and is used to focus on generating shareholder value from current or near-future activities. It is a managerial tool more focused on current activities than is present value. It simply takes the cashflow generated from an activity and deducts a notional charge for the capital required for that activity. There is no argument which relates RORAC to shareholder value since it is not a sensible utility function for shareholders.

CONCLUSIONS RORAC and similar measures are widely used in finance because they focus on capital as a protection to investors in the business and this is central to the regulatory focus. In the form discussed in this chapter they are preferred to regulatory based allocations of capital because they more accurately reflect the risk involved in activities. They also define a sensible relationship between risk and return. They are, however, subject to a number of flaws: they are implicitly a ranking of different risk and return combinations and since they form a linear preference relationship they are likely to be approximations of the managers' or shareholders' attitudes to risk and return. They have some particular features which make them, in general, rather risk averse. They are statistics but are not always regarded as such which means that the discipline of statistical hypothesis testing is not applied to them in situations in which it should be. Their calculation rarely takes account of the marginal impacts on the risk of an organisation's overall portfolio and therefore do not consider any possible hedging impacts of a portfolio. For these reasons they are measures with severe limitations, despite their widespread use.

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13 Risk adjusted performance measures: a critical overview

INTRODUCTION The previous two chapters outlined the basic risk adjusted performance measures and provided a critical evaluation of the individual measures. This chapter draws together the overall arguments and gives a perspective on the measures. It considers the degree to which they can possibly reflect shareholders' attitudes, reviews their use in terms of statistical tests and finally considers how they are integrated into financial institutions.

RAPMs AND INVESTORS' DESIRES The traditional view of finance towards shareholders lies in terms of Portfolio Theory and is expressed by equation 13.1. Investors are interested in the average return on their portfolio and the standard deviation of those returns. The theory implies that investors put their money in the market portfolio that comprises all the assets on offer. The capital asset pricing model (CAPM) and the arbitrage pricing theory (APT) imply that investors only require U = f (E(R),s(R))

[13.1]

compensation for the risks that they face when they hold a widely diversified portfolio. Specific risks associated with individual investments will be eliminated by diversification leaving only

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undiversifiable risks. Investors only receive an extra return through taking extra risk if that risk is not diversified by holding the market portfolio. The differences in the definitions of the CAPM and the APT lie only as to which risks are diversifiable and which are not. In certain instances the CAPM becomes a special case of the APT. There are differences between the actual behaviour and attitudes of investors and those that would be expected from the standard theory. Investors do not put their money in all the assets available to them but in a sub-set of such assets. In this way they may benefit from some covariance properties of investments from which they would not do had they invested in the market portfolio. This perspective is not reflected in the measures based on the CAPM such as the Treynor and Jensen approaches. The Sharpe and Value at Risk approaches do take into account the partial nature of the portfolio that investors actually hold. The time period over which investors are interested in returns is rather short when considered from the traditional theoretical perspective. Most motivations of the standard theories are based on monthly observations but the short- and long-term measures of risk in terms of standard deviations of returns are rather different: deciding how risky an asset is on the basis of historical information depends on the time perspective of the investor. Given the relative returns of different types of investors it appears that the markets reflect a view of risk in relation to short holding periods but this is not necessarily the view from the perspective of all investors. There do not appear to be any measures that reflect the investors' time perspective, but this time perspective may be an important element in reflecting on an adequate risk/return perspective where one is judging the portfolio. Investors may be interested in the average return and in the standard deviation of returns and, in general, one would expect that they are interested in the nature of the precise distribution of returns. If the whole distribution can be characterised by the mean and standard deviation then they should only be interested in these two parameters and their estimators. However, if the distribution needs additional parameters to describe its nature exactly then these additional parameters should be of interest in determining the investors' preferences. RAPMs that are based on only two moments are unlikely to provide effective measures of investors' preferences where more than two characterise such preferences. The use of Value at Risk as a risk measure within businesses in determining their portfolio selection or as the basis for RAPMs has, like RORAC, become best practice within certain sectors of the finance industry. Whether this is related to shareholders' or investors' interests has not been entirely

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RISK ADJUSTED PERFORMANCE MEASURES: A CRITICAL OVERVIEW

considered. Dowd (1998) explores the relationship between Value at Risk and the standard deviation of the distribution of returns and concludes that the Value at Risk is a multiple of the standard deviation provided the distribution of returns is normal. In these circumstances Value at Risk can be incorporated fairly easily in a traditional finance framework but where the distribution of returns is abnormal there is no such relationship. Value at Risk can approximately be described as `a specifically defined estimate of worst case in normal conditions'. RAPMs are implicit linear utility functions and approximate to the actual utility functions of investors. Without considering the precise nature of the definitions of risk one can see the RAPMs in terms of the three different relationships between risk and return depicted in Fig. 13.1. These can be used to categorise all the RAPMs analysed in the last two chapters and any RAPMs yet to be discussed. In considering these as plausible approximations of utility functions it appears that the ordering of (a) to (b) to (c) moves from the worst to the best approximation. In each case the RAPM represented by 1 is considered superior to that represented by 2. In the case of (a) and (b) a riskless investment is marked on the vertical axis and where this lies above the point represented by the intercept of the RAPM measure with the riskless axis the RAPM measure will be infinite. In the case of (a) any riskless investment has an infinite value for the RAPM and in the case of (b) only those above a certain level of riskless return. The slope of the RAPM function represents the investor's trade-off between risk and return. If we take a certain level of risk, as the return increases the slope of the RAPM line increases. In other words, as the level of return rises the degree of risk aversion (defined loosely) rises but there seems no sensible reason why this should be the case. The RAPMs represented by (c) do not suffer from problems either in evaluating the risk free asset nor in increasing risk aversion with increasing returns and therefore appears to provide the most sensible approximation of investors' preferences. Whether RAPMs adequately reflect investors' preferences or not must be viewed in more than one way. One factor is the exact nature of the utility functions of investors and whether any RAPM

Figure 13.1 Implicit utility functions created by RAPMs.

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adequately reflects their preferences. This leads to the questions of what variables should be included in the utility function and the nature of the relationships between those variables. Do, for example, investor utility functions include time and some version of a worst case measure? There is also always the problem of how sensible is a linear approximation of the risk/return relationship. In conclusion, it should be stated that all RAPMs should be used with a degree of caution. Since they are often very approximate estimates of investor utility functions.

RAPMs AS STATISTICS The use of RAPMs to forecast future performance or to evaluate past performance is based on estimating a parameter from a population through sampling. This is true whether we consider RAPMs from an ex-ante or ex-post perspective. The use of an estimator means that the values of the RAPM cannot be considered exact. They are estimates and as a result have a distribution which should be taken into account. The sensible estimation and use of RAPMs should therefore be associated with understanding their statistical properties. In this section we will consider some of the general principles in relation to the information ratio expressed in equation 13.2, which is used to illustrate the general problem. The ratio is that of the expected return on the portfolio and its standard deviation. The information ratio is chosen to illustrate the main points because there is a body of statistical analysis that can easily be drawn on to understand its components. While this is not the case with the other RAPMs the principles outlined in this section apply to them all. Information Ratio = E(R)/s(R)

[13.2]

The estimator for the average return E(R) is outlined in equation 13.3 and the distribution of that estimator in equation 13.4. There are a number of different choices as to the estimator for s(R) but equations 13.5 and 13.6 outline the properties in relation to one particular estimator of the variance of the return. Equation 13.6

100

E(R) = (1Ã/n)SRi

[13.3]

E(RÃ) * N(m, s2/n)

[13.4]

RISK ADJUSTED PERFORMANCE MEASURES: A CRITICAL OVERVIEW

s2(RÃ) = 1/nS (Ri ± E(RÃi))2

[13.5]

s2(RÃ) * ( ((n±1)/n)s2, (2(n±1)/n2s4)) * w2(n±1)

[13.6]

indicates that the estimator of the variance in equation 13.5 is biased since the mean of the distribution is not the actual variance of the distribution of returns. This can be related to the information ratio of equation 13.2. Any estimate of the ratio is made up of an estimate of the expected return which is normally distributed and an estimate of the standard deviation of the distribution of returns which is the square root of the variance whose estimator is in turn distributed w2 (n ± 1). The RAPM estimate has a distribution which is the ratio of an estimator with a normal distribution and the square root of the distribution of an estimator which has a chi squared distribution. Having considered the most statistically simple RAPM it should be obvious that the diagnosis of the appropriate distribution of the estimator of any particular RAPM is more than a little complicated. Once one has identified the distribution from which the RAPM estimator is taken one can use the RAPM either as the basis for prediction of future performance or as a judge of past performance. The accuracy of these processes depends on the distribution and certainly comparing performance with RAPMs is, in essence, hypothesis testing.

RAPMs AND INCREMENTALITY Financial institutions do not hold a comprehensive portfolio of all assets although they are integral to the key models of finance theory. They still retain some specific risks. RAPMs are used to judge investments and returns for specific organisational units. They may be used in relation to a wide range of activities such as a dealing desk, a product, a customer or a business unit. Institutions do not hold the market portfolio of assets and so these activities may have hedging impacts. If one is to evaluate their risk adjusted performance adequately it is necessary to take into account these covariance properties. This suggests that measures such as the incremental Sharpe ratio are more desirable than those, for example, based on the APT or CAPM.

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CONCLUSIONS Each one of the RAPMs has some limitations that have been outlined in this chapter. Although RAPMs are, in theory, related to the wishes of investors it is unlikely that there can be an exact correspondence. They are, at best, approximations. They cannot be measured exactly since the processes generating returns on investment are uncertain and this uncertainty is not, in general, measured adequately. Institutions do not invest in the market portfolio of assets and so there may be covariance impacts that should be included in any sensible evaluation of risk-adjusted performance.

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14 The transfer pricing of derivatives

INTRODUCTION We shall in this chapter not attempt to delve deeply into the complicated and abstruse world of derivative pricing. Perhaps the best introduction to the technical aspects of derivatives pricing is the work, Derivatives: The theory and practice of financial engineering by David Wilmott (1998). There is a wide range of academic papers on derivatives pricing based on the work of Black and Scholes (1973). The focus of derivatives pricing literature has been on those derivatives traded between financial institutions and their large clients. While the presumption is that all parties to the transaction understand the nature of the products in which they deal there is much evidence that even these institutions make mistakes, especially in respect of technical issues such as the accounting and valuation of their derivatives portfolios. There are many different types of derivatives products which are created, bought and sold by financial institutions. The ones that are traded between financial institutions are likely to be the subject of standard and sophisticated analysis on an individual basis and they are less likely to be relevant within a transfer pricing system. The ones that are less likely to receive adequate treatment are those that are created as part of a retail customer relationship: prepayment terms on mortgages and savings products, or products involving the tying of cashflows to market indices are examples of these. There are also a set of `real' options that any business faces and are totally unrelated to the financial markets. The prime examples of these relate to investment decisions establishing a facility which may or may not be used in the future. Such decisions often have importance in valuations within mergers and acquisitions. Within this chapter the treatment of derivative pricing and how it operates is very general and will deal with two areas of derivative pricing that have not yet been discussed sufficiently either in

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academic or practical terms. There are many retail financial products which have embedded options where the behaviour of one party to the transaction may in no sense be described as financially rational. To value these products as if they were obligations between the financially initiated is to misunderstand how they operate. There has also been a trend in recent years to see many business decisions including investment decisions as options and to apply option valuation to their pricing.

THE PRICING OF FINANCIAL OPTIONS The pricing of financial options is an arcane academic and financial discipline and the confine of numerous mathematicians and scientists. There a number of approaches to pricing options that, broadly speaking, are divisible into two. One is the establishing of option pricing formulae, the first of which was derived by Black and Scholes (1973). The other consists of using simulation models based on binomial or trinomial processes. Which type of model is appropriate depends on the option that is to be valued. In particular, many of the options faced by financial institutions are interest rate options which require a specific set of special techniques. The basic models derive from Black and Scholes: they involve the setting up of risk free portfolios using the option and solving for the option price. A formula can be given that shows the price being dependent on the precise nature of the option considered. The simplest formula shows options can be valued in terms of the variables considered V = f ( Pu, X, rf, su, T-t )

[14.1]

in equation 14.1. The value of the option is determined by the following factors: the price of the underlying Pu; the strike price of the option X; the risk-free interest rate rf; the standard deviation or the price of the underlying; and the time to expiry of the option. The price of the underlying Pu is the factor on which the option is written, be it the price of a stock, the interest rate, a commodity or so on. The strike price of the option X is the price at which the option can be exercised. The risk-free interest rate rf is involved in option pricing because the portfolio which leads to the option being priced is perfectly hedged. The standard deviation or variance of the price of the underlying also has an impact on the price because the higher the variability of the option the greater the possibility it may end up at a high price. The final factor in determining the price of an option is the time to the expiry of the option. The longer this time the greater the chance that the option will be valuable. There are several pricing methods based on this theme. One may, for example, consider whether

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having a single measure of the standard deviation of variance of the price of the underlying is a sensible judgement and may make numerous assumptions as to its nature. In general, if it is necessary to price a financial option one should use expertise either internal or external to the organisation. There are many other option models based on binomial and trinomial trees and simulation techniques. This means that the valuation of options depends on a specialist process and any additional specifics to that process may be ignored. Interest rate options are different from others, notably those based on share values which were the ones initially considered by Black and Scholes. The problems involved in respect to the mean reverting aspects of interest rates and the relationships between interest rates require special modelling.

The valuation of embedded options Embedded options are those which form part of the obligations created by a financial product and the commonest examples are interest rate options, considered in this section. Among the most notable examples of embedded interest rate options are fixed rate funding or loans which have a prepayment element. They can be assessed in terms of the value of the asset or liability plus the value of the option. The valuation of these interest rate options is not within the scope of this book. An often used method of expressing the valuation of these products is in terms of an option adjusted spread. If one considers the valuation of the cashflows of the fixed rate contract without any prepayment option, that valuation will vary with time as interest rates vary. At any given point in time it will have a certain value. If at the same point in time we consider the value of the cashflows with the addition or subtraction of the value of the option it will have a different value. The same discount rate is used with these two calculations. The option adjusted spread is obtained by using a discount rate for the valuation of the contract with the option which makes the present value with and without the option the same as the difference between the two discount rates. The mathematical expression of the option adjusted spread is given in equations 14.2 and 14.3. In equation 14.2 the present values of the cashflows without the embedded option are termed PV(N)a where a is the discount rate in the calculation of the present value and PV(W)d is the present value with the option included at the discount rate d. The present value of the cashflows with the

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PV(N)a = PV(W)d

[14.2]

OAS = a ± d

[14.3]

embedded option is set equal to the present value without the option and this is undertaken by changing the discount rate from a to d. The difference between a and d is termed the option adjusted spread (OAS).

Retail options The theory of option valuation is based on the interaction of financially informed transactors, which may well be the case where we are considering options in financial and over-the-counter (OTC) markets. There are, however, many options written by financial institutions in retail markets and the parties who hold the options are not necessarily rational in their behaviour regarding the exercise or otherwise of these options. The most prevalent embedded retail option is probably that of mortgages with a pre-payment option. The exercise of these options by mortgagees is unlikely to be determined by an optimising approach to the problem. The advent of the pre-payment problem in relation to interest rate risk led many institutions, initially in the United States, to produce forecasting models for pre-payments and the need to forecast implies that the options are not exercised on a rational basis. The valuation of these options should therefore incorporate a view of what the likely prepayment profile is likely to be.

BUSINESS OPTIONS One of the most interesting facets of finance, in recent years, has been the increasing understanding that options are not confined to financial markets. Equity and debt are now regarded as options on the assets of a business. The areas in which this perception is probably most easily appreciated are those of capital investment or mergers and acquisitions. A fairly simple example is the internet distribution of a retail financial product as the possible future dominant distribution channel for that particular product range. It may be sensible to invest either through direct expenditure or by acquisition in an internet distribution channel. It is quite possible that this may or may not become a key channel but its effective exploitation will only be available with early entry since there may be first mover advantages. One is buying an option to exercise if the Internet becomes a crucial distribution channel.

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The standard capital appraisal of such an expenditure is to take a main view based on a single and perhaps some risk-based scenarios. It would not focus on the essential financial aspects which are that we are considering an option. Increasingly these real options used to be seen as central to the decision appraisal process.

CONCLUSIONS In setting up an effective system of transfer pricing it is sensible to be able to identify and value the derivatives and, in particular, the options which a financial institution faces. The standard financial markets and OTC derivatives are relatively easy to price given the appropriate software and expertise, although the evidence is by no means convincing that all financial institutions have that facility. It is important to identify the possibility of embedded options and to ensure they are adequately understood and priced. The more difficult issues involve retail options where the transactor or the other side of the transaction may not adopt a financially rational behaviour pattern. Identifying and understanding the behaviour of retail customers is central to the valuation of these options. The final issues concerning options are those that relate to the business activities of the financial organisation. These issues are important in the sensible evaluation of strategic choices.

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Part 4: The strategic perspective This section considers some overview issues involved in the transfer pricing of financial organisations. Chapter 15 looks at an optimising model of a retail bank and how optimisation relates to transfer pricing. Chapter 16 illustrates some frameworks in which transfer pricing can be used and shows how they fit in with the general strategy. It is most important to realise that whatever financial perspective is used for the management of an organisation it should contribute to the overall success of the business.

15 Optimal bank modelling for transfer pricing INTRODUCTION This chapter explores some of the major transfer pricing issues involved in building a non-linear programming model of a financial institution. It is uncertain whether such a model is useful for banking institutions due to their complexity and there is no documentation on their application within a banking framework. The purpose of the model is to illustrate some important issues in relation to transfer pricing for operating expenses, funding, capital and liquidity. It does not explore issues in relation to portfolio evaluation or the pricing of derivatives for financial institutions.

OVERVIEW OF PROGRAMMING MODEL The standard non-linear programming model can be illustrated in simple terms as in problem 15.1. A function is modelled subject to a series of constraints to find what is the optimal setting for a number of choice variables. This setting can be obtained in terms of first and second order conditions derived from first and second order derivatives. The techniques used are the standard Kuhn±Tucker conditions. Problem 15.1 Maximise

P = f(x)

subject to

c 4 g(x) x50

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The problem is to maximise some function of a choice set of variables x where the lower case letters are in heavy type the variable indicated is a vector of values, subject to two sets of conditions. The first set represents a vector of constraints in terms of the relationships of the choice variables, and the second represents a set of constraints where the values of the choice variables are either positive or zero. The solution to the problem can be seen simply in two dimensional terms in Fig. 15.1. Although the problem can be expressed in terms of any number of decision variables Fig. 15.1 typifies the solutions, of which there are two possible, (a) and (b). (a) represents a situation where the maximum for the objective function Po is achieved by setting the choice variable equal to xo. The constraint xc does not stop the maximum value for P to be achieved and is not binding on the solution. In the situation illustrated in (b) the constraint is binding and the global maximum for P, where x is equal to xuc, cannot be achieved. The highest possible level for P is Po and here the choice variable x is at its maximum level relative to the constraint. The important result that forms a vital element of the subsequent discussion is the role of the constraint in determining the solution. The result in (a) is mathematically independent of the constraint and the choice of xo in no way depends on the value of xc. In the situation where the constraint is binding (b) the level of the constraint xc is equal to the optimal choice level for x at xo. The constraint is vitally important in the solution of the best value for the choice variable. Central issues in setting transfer prices are whether the organisation is subject to constraints, the exact nature of those constraints, when they should influence the level of transfer prices and when they should be ignored.

Figure 15.1 Non-linear programming model.

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THE PROGRAMMING PROBLEM APPLIED TO A BANK SITUATION In essence, the programming problem can be related to the banking situation as an example of the theory of the firm. The bank can be seen as a firm and its optimal policy the output of the programming model. This section outlines how that might be modelled and what implications it might have in principle for transfer pricing.

The context of the problem The key to understanding the setting up of the problem is to see decisions today as having an impact on results over a long period of future time. The setting of prices in trading where one has market power or decisions as to the business we take on today can have major implications over time. Indeed, one of the possible perspectives for the valuation of any business in the financial industry is to try and estimate future cashflows and value obligations on the basis of the present value of those expected cashflows. Prices and business taken on today will have impacts over as long a period of time as the products are still in operation. In retail banking one can see the balance sheet size in relation to any particular balance sheet category in the terms of equation 15.2. St is the balance sheet size for the category (an asset or liability product) at time t, and it is determined by the balance sheet size of the same category in the previous time period. The set of factors z will be dependent on decisions, for example, in relation to pricing of other products in the current time period, the actions of competitors and general economic factors. The decisions in relation to pricing will relate to the whole balance sheet because there are strong issues in relation to movements across a bank's balance sheet determined by different pricing of its retail products. If a retail bank, for example, offers some 20 retail savings products, their relative prices will have a major impact on the relative balance sheet values for each of these products. These cross-balance sheet impacts are in general much stronger than the impact of prices relative to those offered by other institutions. They are also stronger, in general, than the sensitivities to outside economic events. St = St±1 + f (z)

[15.2]

where x ( z Such models reinforce the view of the future as vital since the essence of the finance industry is a set of intertemporal relationships. Policy decisions can only be sensibly made with the future perspective in mind and this is particularly true of banking.

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The objective function In order that the programming problem can be sensibly motivated it is necessary to specify the objectives of the business in terms of a mathematical function. Provided that the objectives of the banking institution are financial this appears to be a relatively easy task. The financial objectives of a business from the internal perspective are likely to be shareholder value expressed in terms of objectives for profitability growth and measured by the present value of cashflows or by some economic value. In essence these measures should give the same result and are easy to formulate in terms of an objective function. Some organisations wish to show growing profitability over time and it is possible to establish objective functions which maximise the growth rate of profitability through time. However, there may be subtle rules and constraints in terms of the time path of the profitability that can be generated.

Constraints The constraints in the problem take a number of different forms. Many are related to production functions in the standard theory of the firm. They reflect the interrelationships across the balance sheet which are given in equation 15.2. There are, however, a range of other constraints which are especially important for financial enterprises and they reflect the impact of regulations be they liquidity inspired or related to the enterprises' capital. There may be other types of constraint to which an organisation is subject, as, for example, capacity constraints for processing. Management in organisations can act as a major constraint on activities. There is limited management focus and this is a major constraint on the diversity of projects which an organisation can undertake in any given time period. For instance, a management constraint can set higher hurdles for capital appraisals than those required by the capital markets; the reasoning is that only a limited number of capital expenditure projects can be implemented by an organisation in any time period. There are a further set of non-negativity constraints and they only require that the balance sheet elements and product relationships should not have negative values.

What are the nature of the choices? Maximising an objective function relative to a set of constraints requires decisions and in this case the decisions relate to two interrelated factors. It is possible to take decisions about the pricing of products. If a bank has market power, the decision to price is the equivalent to the decision as to what quantity to buy or sell or the balance sheet size of a particular product category. In cases where

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there is no market influence and the bank faces a parametric set of prices then the issue is what quantity or balance sheet size to buy or sell in each interest rate category.

Product development One of the issues considered in these models is the use of product development in raising funds. It has been noted that retail banks use product development and differential pricing as a means to raise extra funding at lower cost. The new product can be issued at a higher rate and not all existing liability will shift to the new product. The models can explore the time paths involved in the liability flows between products and the optimal way of implementing the policies.

INTERPRETING THE SOLUTION The meaning of the solution depends on the way in which the model is established and it needs to deal adequately with the core issues in relation to risk. If, for example, the problem was set up in a way which did not consider interest rate risk it might advocate taking positions which would expose the organisation to an unacceptable degree of interest rate risk. If, for example, the yield curve slopes upward as in Fig. 15.2, and this was the case throughout the period covered by the maximising model then the expected impact of an optimising model would be to raise funds in as short a term as possible and to lend for as long a term as possible. The results would be very responsive to any assumptions about current and future term structures for interest rates. The injunction to play the yield curve with no attention to interest rate risk would not be particularly informative as a solution to the model. There are, however, some implicit judgements in the nature of the yield curve. The market sets the rate for term t at Rt and for term t+n at Rt+n. This implies that any difference between Rt and Rt+n compensates for the extra risk in the longer term and it is often referred to as the return to interest rate risk. So from one perspective it may be sensible to obtain gains from the yield curve and the operations of the banking, money and capital market institutions do derive returns from such a maturity transference. It would be possible to set up a set of matching transactions off the yield curve to isolate the returns in the solution from interest rate risk and focus on the returns from other factors. The required interest rate risk could be analysed in terms of whatever interest rate risk system the organisation employed. In a retail environment there would be other types of gains from the market power using optimising patterns over different balance sheet products through time. These solutions would provide insights independent of the impacts of interest rate risk management.

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Figure 15.2 The impacts of interest rate risk.

Financial institutions have always regarded their function as, in part, to provide a maturity transference for the economy. They tend to borrow shorter than they lend. Consider the theories for the determination of the yield curve. The expectations-based explanation suggests that rates reflect expectations of future interest and inflation rates and implies there may be no gains on average from maturity transference. The liquidity- and segmentation-based explanations imply that there may be some gains from certain maturity profiles. The argument in this section has been focused on the issues that govern interest rate risk. They can also be extended to cover exchange rate risks, since differences between interest rates in different currencies are related to expected currency changes and relative rates of inflation when a constant real rate of interest is assumed. Again, the institution has a choice of how much exchange rate risk it wishes to undertake.

THE RELATIONSHIP OF THE MODEL AND TRANSFER PRICES It follows from the last section that the optimising model does not have transfer prices as an output. If one compares the model of the firm developed in Chapter 2 with the model described here it can be seen that the basis of optimal transfer prices lies in how the enterprise maximises its objective function. The design of the transfer prices then reflects the fact that if the organisation is broken down into its component parts the maximising behaviour of these parts leads to maximisation of the objective function for the whole organisation. The optimising model is the prerequisite of establishing optimal transfer prices.

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THE IMPACT OF CONSTRAINTS There are a number of different impacts when constraints are included in a mathematical model. If the constraints are not binding they have no impact on the solution of the model. If constraints are binding then they influence the values of the choice variables. In certain situations, some constraints are binding and others not so and in such situations only the binding constraints will influence the decision. This is an important point when one considers the constraints that are derived from the regulatory process for financial institutions. The only constraints that should have an impact on behaviour are those that are binding; for example, the impacts of regulation should only influence pricing or decisions on balance sheet size from an optimising perspective if they are binding. The role of a single binding constraint was discussed in Chapter 10 which outlined the problem in terms of a constraint on the level of capital. The decision rule regarding a single constraint is relatively simple. It is that one should undertake those activities with the greatest return per level of constraint. The return to the constraint was illustrated in Fig. 10.1 (b) which is in part replicated in Fig. 15.3, the return to the constraint being (RaT ± RlT) per unit of value on the balance sheet. In these circumstances there is also a return to the asset product (Ra ± RaT) and a return to the liability product (RlT ± Rl). The constraint can be allocated in terms of establishing value for using the constraint and this value depends on how severely the constraint binds the organisation. This means that the required return on the constraint depends on how severely it binds and if it is not binding there is no required return to the constraint. In situations where there is more than one binding constraint the transfer price of the constraints depends on the impacts of relaxing an individual constraint and can be solved in terms of a

Figure 15.3 Impacts of constraints.

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programming problem. The use of models with more than one constraint are likely to produce behaviour which cannot be predicted in advance but is unlikely to be related to any of the RORAC type models outlined in Chapter 12.

THE RISK RELATIONSHIP OF THESE TYPES OF MODEL The types of optimising model outlined in this chapter have an ambiguous relationship where risk is concerned. They are based on expected values for the variables and these depend on prediction. The forecasts may be subject to a distribution of values and there may be a case for exploring the degree to which the solutions vary with assumptions in relation to the forecasted variables. How to decide on the levels and returns to interest rate risk must also be considered. If the model regards the objective function in terms of maximising present value there will be a discount rate applied that seeks to compensate the providers of funds on a basis dictated by the financial markets. In summing up, there is a role for additional analysis and treatment of risk in relation to any policy prescriptions these models may contain however they are motivated.

CONCLUSIONS This chapter has tried to illustrate, in general terms, the relationships between using an optimal model of the firm to represent bank behaviour and the use of transfer prices. The optimal model of the firm suggests the decisions in terms of balance sheet size and price which will lead to the best position for the shareholder. Such decisions rely on establishing a predicted picture and can, in a sense, be seen as expected values for future variables. Their results, in part, depend on predictions for the yield curve because part of any present value which is generated is a market based return to taking interest rate risk. If desired, this element in shareholder value can be eliminated in models which use yield curve based transfer prices, and in this situation it is debatable how much interest rate risk an organisation should then take. Whatever type of model is used, once optimal values are established for the choice variables then the optimal transfer prices are those which will induce units within an organisation to behave in a way that leads to the correct choices of the different variables if decisions are desegregated.

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16 Transfer pricing and management information strategy INTRODUCTION This chapter considers how transfer pricing issues sit within the framework of establishing a sensible structure of management information for a financial institution. The problem of relating financial to other information is never easy. The development of the balanced business scorecard provides a sensible framework in this type of exercise and its use implies that all institutions are different and that their management information systems should reflect that uniqueness. In this chapter we consider some issues from the above perspective and focus on particular problems. Such problems illustrate important management information issues and their relationship with transfer prices in particular we consider customers, products and the evaluation of distribution channels. It is in essence a plea for understanding the limitations of purely financial goals and information as the core to management within a financial institution.

THE FINANCIAL AND NON-FINANCIAL PERSPECTIVES In the previous chapter an optimising model of a financial institution was outlined. There it was seen entirely in financial terms and the decisions related to pricing could be broadened to consider product development. Provided it is feasible to outline the impact in terms of the product on costs and revenues through time it may be possible to model the impacts of using product development as part of the institution's strategy. If systems of transfer pricing are based on optimal modelling it is possible to establish decentralised management where units are motivated by financial performance.

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This is undoubtedly a sensible management perspective especially where the goals of an institution are financial. However, from a strategic perspective they reveal distinct limitations. Many strategic perspectives in the monetary industry are concealed if institutions are seen solely from the financial perspective. Such perspectives include those of quality, customer management, and technological development which have recently received attention. If one establishes a system of transfer pricing it is important not to lose the essential strategic perspective within which any sensible finance based management information system should be lodged. The development of the concept of the balanced business scorecard as a strategic management system has led to the combination of the financial and non-financial in a balance which is specific to the organisation. It can be applied to any organisational level and to any perspective and if done so successfully will provide consistency for the whole organisation. It has some similarities with transfer pricing for it is a way in which an organisation can become less centralised in terms of management responsibilities while still providing a framework within which it can give consistent management across the whole enterprise.

DISTRIBUTION CHANNELS One of the biggest changes in recent years has been in the distribution of financial services as evidenced by a revolution in the technology and increased globalisation. In the retail field, the role of field sales forces and branches has seen competition from other modes of distribution, most notably the telephone and, more recently, the computer. Financial institutions have always suffered problems in their distribution channels. This is illustrated by Hand and Smullen (1998) in their consideration of retail branch banking in the United Kingdom. The key to establishing good profit or investment centres is to ensure that the unit considered can be set up so that its costs and revenues are strongly influenced by its activity and that responding to its costs and revenues provides behaviour congruent to the objectives of the organisation of which the unit is part. Through transfer pricing artificial profit centres are set up within an organisation that will only be effective if they create activity congruent with the organisation's overall goals. It appears that every large retail financial organisation has established a branch profitability system, but has been dissatisfied with the results. The reasons for the dissatisfaction have been outlined in (Smullen 1995a) and can be summarised as

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follows. The branches of retail financial organisations are responsible for the implementation of many strategic functions of which the most common are selling, transaction processing and customer management. To relate these functions to the overall success of the organisations is not easy and to see them in terms of branch profitability is very difficult. Selling is, in many ways, the easiest to consider within a financial framework. The sale of a standard retail financial services product leads to a set of cash flows over a period of time which will probably be longer than the organisation's accounting period. In some cases the cash flows will be predictable given that they are contractually specified: however, in the case of many products there is no contractual obligations in terms of cash flows such as with chequing accounts or savings accounts. The result is that any consideration of branches in terms of profitability will not focus adequately on the overall shareholder value impacts of selling in a particular time period. Another reason for the dissatisfaction lies in the relationship between transaction processing and customer management on the one hand and profitability on the other which is very confused at a branch level. The reason why transaction processing and customer management are undertaken is to improve the financial performance of the organisation but the links between them and financial performance are very ambiguous. One frequently encounters such situations in business where activities are undertaken although their links to financial performance are tenuous and are acts of faith in many businesses. They are particularly difficult for those of a financial background to understand or evaluate but are key to most successful organisations. Evaluating the impacts of transaction processing or customer management on profits or value is almost impossible and any attempt to do so may produce mathematical results in which one has no confidence. To summarise: although one can provide sensible estimates of the shareholder value impacts of sales it is impossible to quantify financially the impacts of branches on their other strategic goals. The role of transfer pricing in these situations is therefore limited to providing an element in the assessment of the shareholder value contributed by sales. It is necessary to discuss the most rational way in which a branch should be seen from a management information perspective after accepting the above analysis. The following case study illustrates a sensible response to the problem and it is drawn from a variety of discussions with industry participants. It applies the tool of the balanced business scorecard to the problem of producing a set of strategic measures that combine the strategic and financial perspective. The scorecard is illustrated in Fig. 16.1.

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Financial

Value of sales Budget performance

Customer

Customer recruitment Customer retention Customer value Market share

Complaints Service quality Cross selling

Processes

Lead generation Sales/interviews Errors

Efficiency Process productivity

Change

Staff experience Staff training Staff morale

Figure 16.1 A branch performance scorecard for a retail bank. The generic scorecard sees strategy implementation in terms of different perspectives: financial, customer, internal processes, and change and innovation. It is based on the principle that a comprehensive strategy is likely to incorporate all these elements. Once an overall organisational strategy is specified it can be cascaded down to individual units in terms of a general strategic information system. Figure 16.1 gives a hypothetical branch scorecard and is an application of the overall strategy to branches. The financial indicators should be designed to focus on those financial impacts that the branch can influence directly. The value of branch sales is the central financial indicator of its revenue or valuegenerating activity. The other major impact of branch activity that can be measured by a financial metric is the expenditure of the branch on resources which means that budgetary control should form a most important element in branch financial evaluation. These two indicators will not encapsulate adequately all the roles the branch is expected to fulfil but will cover the ones for which we can produce sensible financial metrics. The customer relationship is a central element in the success of any business and can be regarded from a number of vital perspectives. Approximately 10% of retail bank customers generate 80% of banks' profits which means that not all customers are of equal value to the retail financial institution. Customer profitability is one measure of the financial contribution of a customer to the organisation but given the long term relationship associated with most products it is often better to consider customer financial contribution from a shareholder perspective. The inclusion of customer value in the customer section of the scorecard instead of in the financial section is of little or no significance.

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The key is to have the appropriate strategic indicators included: the individual section is of far less relevance. The precise indicators depend on the given strategy. Customer retention and recruitment are often seen as alternatives to each other; in financial services where so many customers may be unprofitable this type of targeting is likely to be more specific than indicated by these two simple metrics. Complaints and quality of service indicators ensure that the branch sees itself as the customer sees it for these are important prerequisites for adequate customer service. The market share indicator compares outlets with those of its direct competitors. The processes scorecard depicted in the illustration seeks to give some indication of how the objectives will be obtained specifically. It is important to target both results and instrumental behaviour. Central to the strategy of all organisations is the specification of the nature of changes to be achieved and the implementation of change. The changes required of most organisations tend to be organisationspecific and so it is difficult to generalise. If, however, one considers financial services over the past ten years the key changes have been the following: the development of more sophisticated product ranges, greater employee skills, improved technology and better software. The crucial role within branch management has been to ensure that the personnel and training aspects of these changes are adequately managed which means that the key change indicators are related to personnel issues. Within the strategic information system for branches outlined above there is a key role for transfer prices and information based on them. The valuation of sales and customers can only be undertaken where transfer pricing can be carried out. This means that the role for transfer pricing is embedded within the information structure of the organisation which is specific to the institution although there will be some similarities between organisations.

CUSTOMERS The appropriate consideration of customers is also a difficult and problematic exercise even if one confines one's judgement to purely financial issues. The background and some of the arguments in this section are derived from Smullen (1995a, 1995b and 1998). Given that many customers of financial services organisations are patrons for life any sensible consideration of what they contribute individually to the shareholders should take a long-term perspective. It may be deduced from the hypothetical profile of customers that, in general, the fewer the products the shorter term is the

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Figure 16.2 Customer value. perspective over which value is generated. The present value profile of a customer which is retained by an organisation is typically as illustrated in Fig. 16.2. (Smullen 1998) Customers recruited at the beginning of their working life remain customers until retirement. The present value of customers is highest when they are in their middle forties. There is much else that is significant about this profile. The present value at the time of the first relationship between the customer and the bank is about one-quarter of its value at the peak. It is also significant to see at what period in the life cycle it is most appropriate to recruit or retain the customer which should also be considered in terms of the values and probabilities associated with the customer relationship. One of the ways which customer analysis has been undertaken by a number of institutions is by trying to identify the most appropriate type of customer in terms of factors and financial returns. One might see customer segments in terms of Fig. 16.3 which indicates the relationship between customer segments, social groupings, age and financial returns. The location of the rectangle indicates the social grouping and the age of the customer segment. The length of the segment indicates the time period that, on average, the customer remains with the institution and the vertical size of the rectangle indicates the average financial value of a customer. Such analysis indicates the customers which an organisation should favour in its marketing policy.

Figure 16.3 Customer segmentation.

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The appropriate financial perspective may require much imagination and ingenuity as detailed by the analysis of customers described in this section, and the nature of the appropriate perspective which incorporates transfer prices may often be organisation specific.

CONCLUSIONS This chapter has argued that the context of transfer pricing is at least as complicated as the generation of appropriate transfer prices. The understanding and motivation of an organisation from a financial perspective is helped by transfer prices and the appropriate financial perspective is a complicated and organisationally-specific judgement. Relating financial and non-financial information is always complicated and it is vital to realise that there are policies and strategies in every organisation that are difficult to understand solely from a financial perspective even where there may be an obvious financial approach to units within an organisation as illustrated by the inclusion of sections on distribution channels and customers. The creation of good financial information requires very careful and subtle consideration of what is appropriate for the organisation.

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Part 5: A review of key issues and conclusions Chapter 17 is a review of the major issues and conclusions raised within the book. It outlines the main areas likely to create problems in the implementation of a sensible system of transfer pricing within a financial organisation. It suggests that the orthodox view of finance generated by the academic community does not seem to provide a background that is completely sufficient for the understanding of practices within financial organisations; indeed, the practice of institutions is not embedded in any theoretical framework that is entirely adequate.

17 Issues and conclusions

INTRODUCTION This chapter discusses the major issues raised in the rest of the book which impact on the sensible introduction of transfer prices within a financial organisation. The book is not a blueprint for the staged introduction of a set of transfer prices as was stated at the beginning and in this chapter it is made clear why the introduction of transfer prices needs to be specific to the organisation. While the book is an aid to understanding the issues, it is not a solution.

NO SINGLE TRANSFER PRICE A transfer price should be fit for the purpose and there are a great diversity of different transfer prices. In general, fully allocated-based transfer prices are unsuitable because they may lead to dysfunctional behaviour. However, in providing a justification for pricing to a regulatory body or to an organisation supplying joint services with others it may prove to be a sensible basis for pricing. Any given financial organisation has many purposes for which it wishes to generate transfer prices and there is no single perspective that is entirely appropriate. It is an individual choice that can only be understood in terms of a specific organisation. However, there are many important general principles that must be recognised.

TRANSFER PRICING SYSTEMS ARE APPROPRIATE FOR FINANCIAL INSTITUTIONS In Chapter 3 the systems of transfer pricing used in commercial organisations were reviewed. Interestingly, it was concluded that a very large number of businesses internationally use a full cost basis for transfer pricing which is strongly at variance with the tenets of economic and accountancy

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theory. The generation of cost-based transfer prices in most organisations suffers from difficulty in understanding the nature of the cost structure and, in particular, the factors which lead to its variations. This problem appears to be increasing because the proportion of costs formed by the basic inputs to production (for example, material inputs) are declining as a proportion of total costs. The development of activity-based costing has helped answer some of these problems: however, it does not provide an entirely adequate solution. For financial institutions the situation is rather different: material inputs for such an institution are the financial obligations which it buys. The most obvious example of this concerns its funding. Financial institutions borrow money which they lend or invest and it is therefore much easier to identify their costs than it is in the case of other commercial organisations. The bulk of costs for financial institutions are those concerning the financial relationships into which it enters and the interest cost is invariably the largest cost for banking institutions. Financial organisations therefore have a much better understanding of what drives their costs. They can also show how their costs relate to revenues because these revenues are derived from financial obligations which are based on their costs and so have a greater understanding of their cost structure. It is therefore easier for a financial institution to construct a system of transfer prices than it is for the standard commercial organisation.

MARKET-BASED PRICES AND MARKET POWER The inputs of a financial institution can easily be understood because there are market prices to which it can refer. If an organisation has market power the derivation of optimal transfer prices as illustrated in Chapter 2 requires an understanding of marginal costs and revenues. When considering outside markets the estimation of these marginals may be difficult and so this can be a complicating factor. As a general rule, in wholesale markets an organisation does not have excessive market power and the problem is mainly associated with the institution's activity in retail markets. In these cases, retail and wholesale obligations, although they have some differences, can be understood as substitutes for each other and the wholesale prices are likely to provide sensible marginals.

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MATCHING When establishing a detailed system of transfer pricing with a fine grain understanding of the way a business works, it is important to ensure that a market-based price is used. In essence one should ensure one is matching like with like. The most complicated example of this concerns a transfer price for funds. If one is establishing such a transfer price, for example on a transactions basis, one should use a price based on the following similarities: the timing, the term, the risk profile, and the currency. Any other attributes should also be the same.

MOTIVATION The calculation of any optimal-based transfer prices must be founded on a specification of an objective function. This function encapsulates the objectives or goals of the organisation. Much of the uncertainty that occurs when establishing sensible systems for the evaluation of risky returns depends heavily on a perception of organisational motivation. The key motivations that need to be understood concern shareholders, managers and regulators. Traditional financial theory sees shareholders as interested in the average level of returns which consist of dividends and capital gains and the standard deviation of those returns. There are some grounds for seeing these as only approximations of the shareholders' approach to utility maximisation where they are interested in the whole distribution of returns and choices between those distributions. If the distributions are normal then the mean and standard deviation will provide an entirely adequate description of the distributions. Where distributions of returns are not normal then other statistics may be required to specify the distributions. In this context, shareholders may be interested in various worst case measures of which value at risk is one such. The ordering of investments in terms of risk between bills, bonds and shares depends on the time period over which returns are measured (as detailed in Chapter 6) and so it may be sensible to include issues concerning time in the utility function. If one were to broaden the utility function by these additions, shareholders' utility would depend on average returns, the standard deviation of returns, value at risk and the investment time perspective. The standard deviation of returns may be seen as a substitute for value at risk, but not necessarily so, because investors may be interested in both measures of risk. The broadening of the shareholder perspective will have two important implications. Firstly, the traditional theory of finance will no longer provide an adequate framework for understanding shareholders' motivations. Secondly, any measurement based on two arguments in the utility

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function is likely to be a poor approximation of shareholders' desires, which means that one must be sceptical of any risk adjusted performance measures. Given the standard way in which banks organise their risk management, (Bressis 1998) it is interesting to ask whether shareholders have preferences in relation to the credit rating of the bank. Shareholders may be interested in the value at risk of their returns but it is difficult to establish a link between rating and shareholder returns. The most likely relationship by which shareholders would be interested in credit ratings is that by which better ratings were associated with increased returns. The motivations of managers may not accord with those of shareholders although there will be some identity of interest because managers are likely to have shares and share options in their own institution. It is, however, difficult for managers to hedge their dependence on their own firm and it is therefore probable that they will be more sensitive to risks than shareholders. Regulators are interested in a number of considerations. They attach importance to the efficiency with which financial markets operate, so are concerned with issues of transparency and freedom from abusive practices. The stability of the financial system and the international economy has vital consequences for them. Their focus in terms of liquidity and capital regulations ensures financial stability. The adverse outcomes likely to be encountered by any institution can be matters of serious gravity for regulators. Given that shareholders, managers and regulators are the key stakeholders who influence decisions within financial institutions one must ask how their interests should be regarded in establishing transfer pricing systems. In theory, the shareholders own the businesses, the managers are agents for the shareholders and the regulators establish the framework within which the business can be managed. This implies that the desires of shareholders form the function to be maximised subject to the constraints of regulators and perhaps minimises the agency issues of the role of managers.

ARE TRANSFER PRICING SYSTEMS EXCESSIVELY RISK AVERSE? The definition of risk aversion at its most standard states that shareholders' utility is increasing in average return and decreasing in the standard deviation of returns. During the course of the book the

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term has been used in a wider context and states that shareholders' utility is increasing in average return and decreasing in any measure of utility. This latter definition is used here. A simple perusal of the three chapters (11, 12 and 13) on RAPMs reveals evidence that these measures are in general highly risk averse. Many of the measures see the risk free return as having an infinite value for the relevant RAPM. An even greater number of the RAPMs suggest that as returns increase, the degree of risk aversion increases. The first of these points certainly does not reflect shareholders' wishes while the second is unlikely to do so. If shareholders are disinterested in the rating of banks then the allocations of capital and returns in relation to those capital allocations are unlikely to have any meaning for shareholders. They may, however, have importance for regulators and managers.

RELATING TRANSFER PRICING TO STRATEGY It is insufficient to see transfer pricing in terms of the objectives of a particular financial organisation: one should also see it in the way in which a business seeks to fulfil those objectives, usually in terms of organisational strategy. The technique of balanced business scorecards is a way in which to specify the necessary strategic information to form the basis for strategy implementation; transfer pricing in financial institutions should be seen as a key building block in these information systems. If transfer pricing systems are not to create dysfunctional decision making it is important to set them within an appropriate strategic framework.

CONCLUSIONS The establishment of transfer prices should be congruent with an organisation's strategy: this is a most important insight concerning transfer pricing for financial institutions. Such establishment should reflect the objectives of the organisation and how it wishes to fulfil them. There is no definite general programme for the easy implementation of the establishment of transfer prices. There are a number of techniques that institutions tend to use and these are outlined in the text of this book.

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144

Index accounting department, 55 activity, 26, 27, 28, 37, 54, 55 activity based costing, 53±6, 130 age, 124 arbitrage pricing theory (APT), 42, 48, 97±8, 101 asset and liability management (ALM), 63 assets, 57, 62±3, 105 asset pricing models, 41±2 Atkinson, R, 15, 53 ATM networks, 23 Australia, 18 Automated Teller Machines (ATM), 5±6 average cost, 16, 54 average funding rate, 60, 69±70 Bafcop, J, 18 balanced business scorecards, 36, 119±23 customer scorecards, 36, 122 financial scorecards, 36, 122 internal business process scorecards, 36, 122 learning and growth scorecards, 36, 122 balance sheet, 26, 62±3, 67, 69±70, 75±7, 113±14, 118 Bank for International Settlements (BIS), 7, 74±5 basis points, 73 Basle, 75, 77 benchmarking, 22±4 benchmark portfolio, 86 beta, 42 bills, 48, 131 binomial processes, 104±5 Black, F, 81, 87±8, 103±5 bonds, 48, 82, 131 borrowing, 39, 59±63, 130 Buckman, A, 16, 20 budgetary centre, 26, 29 budgetary performance, 122 budgeting, 22, 29, 54 Building Society, 69 Buser, S, 72 business options, 106 business plan, 28

business units, 26, 27, 101 branch profitability system, 120 branches, 27, 28, 120±3 branch strategy, 121±2 Bressis, J, 90, 132 Canada, 18 capacity, 114 capital, 22, 24, 71±8 capital allocation, 29, 31, 46, 77±8, 90±6 capital appraisal, 55, 73, 107, 114 capital asset pricing model (CAPM), 41±2, 48, 82±4, 86±9, 97±8, 101 capital at risk (CAR), 74, 77±8, 90±5 capital gains, 35±6, 131 capital markets, 39, 114 capital projects, 55 capital regulation, 22, 24±5, 74±7 capitalist economies, 8 cards, 23 cashflow, 26, 73, 105, 113, 121 Chen, A, 72 Chenhall, R, 18 chequeing accounts, 121 cheque writing, 56 Chittenden, J, 62±3 Chorafas, D, 30 Chu Yang, H, 60 competition policy, 22 competitive advantage, 39 complaints, 122±3 computer, 120 constraints, 75±7, 111±18 corporate funding, 62 corporate strategy department, 57 cost allocation, 4, 38, 56, 57 cost based pricing, 29 cost centre, 27 cost drivers, 54, 55 cost objects, 53, 54, 55, 57 cost of funds, 59±65 costs, 53±58

145

INDEX

cost object specific fixed costs, 57 cost of funds, 59±65 directly variable costs, 57 fixed costs, 56±7 managerially variable costs, 57 notional costs, 60 overhead costs, 54, 57 step costs, 56 total costs, 57, 130 variable costs, 56±7 cost structure, 129 credit rating, 39, 46, 66, 67, 68, 69, 95, 132 credit risk, 29±30, 75, 77±8, 90±91 credit risk amendment, 75 crisis, 68, 70 cross balance sheet impacts, 113±16 cross selling, 122 currency, 30, 43, 131 current risk profits, 62±3 customers, 26, 35, 37, 38, 54, 55, 65, 67, 69, 101, 103, 119, 123±5 customer financial analysis, 37, 38 customer management, 120±1 customer profitability, 69, 122 customer recruitment, 122±4 customer relationships, 69 customer retention, 122±4 customer scorecards, 36 customer segment, 124 customer service, 123 customer value, 122, 124 dealer, 37 dealing, 27 dealing desk, 101 debt, 71±2, 106 debt holders, 95 decisions, 22, 26, 29, 38, 55 decision appraisal, 73, 107 decision specific transfer prices, 32 definition, 3 demand, 75±7 derivatives, 32, 103±6 discontinuities, 66, 69±70 dysfunctional behaviour, 9, 17, 27, 35, 129 dysfunctional decisionmaking, 70 dysfunctional incentives, 39 distributional channels, 26, 55, 106, 120±3 distributional units, 3, 27 dividends, 35±6, 131 dollar, 62 Dowd, K, 45, 46, 86, 93

146

Drumm, J, 18 Drury, C, 59, 60 duration, 68 e-commerce, 73±4 economic value, 25, 26, 29, 35±6, 43, 96, 114 Economic Value Added (EVAR), 26 effective duration, 68 efficiency, 122 efficient market hypothesis (EMH), 43, 79±80, 93 equity, 38, 71±3 equity required return, 73 embedded options, 29, 32, 104±6 Emmanuel, C, 18, 54 employees, 35 employee skills, 123 employment costs, 56 equity, 106 errors, 122 estimator, 100 Euro, 62 exchange rate risk, 7, 62±3, 75, 116 expectations, 116 extreme value modelling, 46 extreme values, 46 Fama, E, 43, 79 finance department, 54±5 finance theory, 40±3, 47±8 financial accounting, 55 financial appraisal, 55 financial obligations, 57 financial organisations, 58, 129 financial scorecards, 36 financial services industry, 71 fixed rate contract, 105 fixed rate funding, 105 forecasting models, 106 France, 18 full cost transfer pricing, 16±20 fully allocated, 129 funding, 38±9, 59±63, 71±3, 130 funding costs, 39, 130 funding decision, 37 funds, 29 gearing, 71±2 Germany, 18 globalisation, 120 Gould, J, 8 government, 4 Grossman, S, 43

INDEX

groups, 26 Hand, N, 120 headcount, 56 Hirschleifer, J, 8 historic risk profits, 62±3 hypothesis testing, 101 incrementality, 101 individuals, 26 individual transaction, 60, 63 inflation, 116 information efficient equilibria, 43, 80 information gathering system, 57 information ratio, 100±1 interest rate cycle, 68 interest rate options, 104±5 interest rate risk, 7, 39, 60, 62±2, 75, 115±16, 118 interest rate swaps, 64 internal business processes scorecards, 36 International Monetary Fund (IMF), 5 internet, 106 interrelationships of units, 37±9 interviews, 122 investing, 59±63, 71 investment, 73, 79±89, 130 investment centre, 27, 120 investment decisions, 104 investment portfolios, 79±89 investors, 47, 72 invoices, 55 Japan, 18±19 Jensen, M, 81, 84±5, 98 joint profit maximisation, 10±14 joint services, 129 joint venture, 3, 5, 23 Jorion, P, 41 Kane, E, 72 Kaplan, R, 15, 36, 53 Kawano, R, 60 Khanna, S, 60 Kuhn, H, 111 Lange, O, 8 lead generation, 122 learning and growth scorecards, 36 legal requirement, 55 lending, 39, 59±5, 71, 130 liabilities, 57, 62±3, 105 Lintner J, 41

liquidity, 45, 114, 116, 132 liquidity regulation, 22 London Inter Bank Offer Rate (LIBOR), 60, 67 long term funding, 71 Mabberley, J, 54 management, 114, 120, 131 management accounting, 55 management information, 119 management requirement, 55 managers, 47, 132 manpower, 57 marginal cost, 15, 75±7 marginal cost of funding, 69±70 marginal revenue, 75±7 market based transfer pricing, 18±19, 43 market economy, 71 market efficiency, 43, 79±80, 93 market indices, 103 market power, 130 market premia, 42, 83 market risk, 29±30, 64±5, 78, 92 market risk amendment, 45, 46, 61, 64±5 market share, 122±3 Markowitz, H, 40 markup, 16 matching, 131 material inputs, 130 maturity mismatch, 39 maturity transfer, 115±16 MBS, 18 Mehafdi, M, 18, 54 mergers and acquisitions, 22, 23, 103 Merton, R, 72 Millar, B, 16, 20 Millar, M, 36, 72 mismatch unit, 62 Modigliani, F, 36, 72 money market instruments, 82 Monte Carlo simulation, 46 mortgage, 74, 103, 106 Mostafa, A, 18 motivation, 22, 29, 131 multinational transfer pricing, 19 multiple pool, 60±1, 62 National Westminster Bank, 103 negotiated transfer prices, 17±19 Netherlands, 41 non-financial information, 28, 35, 37±8, 119±25 non-financial organisations, 58, 72 non-linear programming models, 111±18

147

INDEX

Norton, D, 36 notional cost, 60 objective function, 111±12, 114 offsetting, 30 operating expenses transfer pricing, 30±1, 53±8 operating units, 57 operational risk, 29±30, 78 optimal modelling, 111±18 optimal planning, 8 optimal transfer pricing, 8 -14, 19±20 options, 28, 103±7 embedded, 32, 104±7 real, 32, 103 retail, 106±7 option adjusted spread (OAS), 105±6 option pricing, 28 organisational management, 6, 24±9 organisational units, 27, 28, 35, 53, 55, 101 outsourcing, 5, 22, 23 overheads, 54, 57 over the counter, 106±7 parameter, 100 parametric prices, 115 payments processing, 55 personnel, 123 planning, 6, 22, 29, 54 planning units, 29 portfolio returns, 31 portfolio theory, 37, 40, 42, 44, 45, 79, 87, 97 postal surveys, 18 predetermined margin, 60±1 prepayments, 103, 105±6 present value, 25, 26, 36, 43, 75, 96, 105±6, 113± 14 price, 114 price maker, 64, 66±70 price taker, 64, 66±70 pricing, 22, 29, 64, 67±8, 111±18, 119 pricing for services, 22 processes, 3, 26, 28, 55 process productivity, 122 product development, 115, 119 product diversity, 54 products, 3, 26, 27, 28, 37, 53, 55, 64±5, 67±8, 101, 103, 105±6, 113±15 production department, 8±14 profitability, 24, 26, 27 profit centre, 120 profits, 121 profits growth, 114

148

projects, 3, 6, 26, 28, 38, 55 quality, 120 quantity of trades, 64, 114 real options, 32, 103±4, 107 regulation, 4, 22, 61, 68, 71±2, 74±8, 96, 114, 117, 129 regulators, 47, 131±2 regulatory capital, 90, 132 regulatory intervention, 47 relationships, 69 remaining term, 62±4 repricing, 63±4 required return, 29 retail branch banking, 120 retail customer relations, 103 retail financial products, 104, 113 retail financial services, 38, 60 retail funding, 64, 66±70, 75±7 retail funding and lending transfer price, 65 retail lending, 64, 66±70, 75±7 retail options, 106 returns, 41 expected returns, 41, 42 normal distribution of returns, 45 standard deviation of returns, 41, 42, 45 return on market, 42 risk free, 42 variance of returns, 41 return on market, 42, 83±4 return on risk adjusted capital (RORAC), 46, 74, 78, 82, 90±6, 98 revenue centre, 27 risk, 28 exchange rate risk, 62±3, 116 interest rate risk, 7, 39, 62±3, 118 risk adjusted performance measures (RAPMs), 40, 47, 51 79±102, 132±3 risk aggregation, 37±8 risk averse, 41 risk free return, 42, 83±4, 86±7, 93, 104 risk management, 4,5, 7, 22, 29±30, 37±8, 72, 118 risk management unit, 30, 39 risk profile, 131 risk return, 28, 29 Ross, S, 42 sales, 65, 121±2 sales forces, 120 savings accounts, 121 Savings and Loan, 69

INDEX

savings product, 73±4, 103, 113 Scholes, M, 103±5 segmentation, 116 selling, 121 selling department, 8±14 service quality, 122 shareholders, 24, 35, 94, 97, 118, 131±2 shareholder value, 35±6, 75±7, 114, 118, 121±2 shareholder value maximisation, 75±7, 96 shares, 48, 82, 131 Sharpe, D, 19 Sharpe, W, 41, 72, 81, 85±7, 98 single country transfer pricing, 18, 19 single pool, 60±1 average rate method, 60 marginal rate method, 60±1 Smullen, J, 16, 69, 120, 124 social category, 124 socialist economies, 8 software, 123 staff experience, 122 staff morale, 122 staff training, 122 stakeholders, 35, 132 statistics, 88, 96, 97, 100 stickiness of funds, 68, 70 strategic choice, 107 strategy, 22, 109±25, 133 strategic information system, 36 strategic performance measures, 32, 121 Stern Stewart, 26 Stiglitz, J, 43 strategic business unit (SBU), 26, 27 strategic information systems, 122±3 strategic issues, 27 stress testing, 46 supply, 75±7 Tang, R, 18 taxation, 4, 5 tax shields, 72±3 technical forecasting, 81 technological development, 120 technology, 120, 123 telephone, 120 telesales, 57 term, 30, 43, 61±64, 115±16, 131 theory of the firm, 111±18 time, 47, 98, 131 timing, 131 Tomkins, C, 16, 18 training, 123

transaction, 65 transactions processing, 121 transfer pricing capital, 31, 40, 51 decision specific, 32 derivatives, 32, 40, 51 funds, 6, 31, 40, 51, 59±70 market based, 18±19, 43, 130 operating expenses, 30±1, 40, 51, 53±8 portfolio returns, 31, 40, 51 retail funding, 64±70 transfer price of funds, 6, 31, 40, 51, 59±70 treasury, 27, 30, 39, 62 Treynor, J, 81±5, 87±8, 98 Treynor-Black, 87±8 trinomial processes, 104±5 Tucker , A, 111 underwriting, 37, 39 United Kingdom, 18, 35, 41, 120 United States, 18, 35, 48, 106 utility, 41, 42, 79±89, 92±4, 96±100, 131±2 value creation, 36 Value at Risk (VAR), 31, 37, 44±6, 47±9, 77, 81, 91±3, 98±9, 131 absolute Value at Risk, 44 cut off value, 45, 46 historical method, 46 Monte Carlo simulation, 46 relative Value at Risk, 44 time period, 44±5, 46, 91 value of a sale, 122 Vancil, R, 18 variable cost, 15±16, 18-19 variable rate loan, 64 variable rate obligations, 63 variety, 54 vectors, 112 wholesale funding, 64, 66±70 wholesale lending, 64, 66±70 Wilmott, D, 103 World Bank, 5 worst case, 44, 46±7 Wu, F, 19 yen, 62 yield, 61±4, 115±16 yield curve, 61±4, 115±16 Zimmerman, J, 20

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