ALM and Internal Transfer Rates

Question 1

What is the internal transfer of gross cash flows?

Answer 1

Every single cash inflow is virtually sent to the Treasury division and every single cash outflow is virtually generated by the Treasury division
* The financial statement of the branches is perfectly hedged
* Only Treasury bears some interest rate risk

Question 2

What is the internal transfer of net cash flows?

Answer 2

Only the net cash flow of each branch is transferred to Treasury.
* Part of the ALM is performed by the branches

Question 3

Which system of internal transfer rates is usually preferred?

Answer 3

A system based on the internal transfer of gross cash flows is usally preferred because:
* A system based on the internal transfer of net cash flows uses a single transfer rate for cash flows of different maturities
* A system based on the transfer of net cash flows leaves part of the interest rate risk to the branches
* The interest rate risk of the bank is different from the sum of the exposures of the various branches

Question 4

What should the choice of the Internal Transfer Rate consider?

Answer 4

The choice of the ITR should:
* Be grounded on market rates
* Distinguish between bid and ask rates. For a virtual liability we should use an ask rate, for a virtual assed a bid rate.
* Consider every single cash flow as a separate operation.

Question 5

What are the specific of choosing the ITR for a fixed rate transaction?

Answer 5

For a fixed rate transaction the ITR is chose only once at the beginning of the transaction

Question 6

What are the specifics of choosing the ITR rate for a floating rate transaction?

Answer 6

The ITR for a floating rate transaction changes after every renegation of the floating rate operation.

Question 7

What are some of the problems when choosing the “administrative rate” ITR?

Answer 7

ITR for operations indexed to “administrative” rates has a couple problems:
* No financial instrument is available in the market to hedge the related interest rate risk
* It’s difficult to measure (and therefore transfer to treasury) basis risk

Question 8

What is the prefered ITR when dealing with administrative rates?

Answer 8

When dealing with administrative rates prime - spread is preferred, as it grants a complete transfer of interest rate risk to treasury (basis risk). The branch only deals with credit risk. This leaves it impossible for the treasury to hedge the basis risk.

Example of prime - spread rate. Mortgage granted at Prime Rate + 0.25%. Prime rate estimated to be Libor + 2% (based on historical values). ITR set to Prime Rate - 2%, branch is fully hedged but treasury faces basis risk.

Question 9

What are the ideal characteristics of an ITR System?

Answer 9

1. An ITR system should be such that the resulting profits of the different operating units is equal to the global profitability of the entire bank
2. The ITR system shuold be based on a gross cash flow system
3. The ITR system should be based on rates differentiated by maturity (multiple ITR)
4. The ITR system should be based on market rates, that can be actually negotiated by the treasury
5. The ITR system should be based on different rates for assets and liabilities (bid and offer rates)
6. The ITR system should be such to protect operating units from changes in the interest rates (directional risk)
7. The ITR system should be such that branches profitability changes only come from credit risk (other than operating revenues and costs), not from interest rate risk
8. Operating units should not be hedged from basis risk unless this risk can in turn be hedged by the treasury in the market
9. The ITR system must be such to protect the operating units from the risks related to implicit options
10. The ITR system must be arbitrage-free, the operating units must not be able to realize arbitrages against the treasury