All depository institutions have interest rate risk (IRR) and liquidity risk (LR). These are risks which arise from differences between the re-pricing and liquidity characteristics of assets and liabilities. The natural tendency for banks is to be liability sensitive and short liquidity (see my explanation for the reason behind this tendency), but even if a bank believes that it is asset sensitive and has minimal liquidity risk, risk positions are constantly shifting. As interest rates rise, asset duration extends (as mortgage prepayment speeds slow) and funding duration shortens (as depositors seek to take advantage of more attractive rates in the marketplace); balance sheet mix, competitive dynamics and regulatory requirements also change, so it is incorrect to think that there is anything static about a bank's IRR and LR profiles. In addition, it is important to recognize that IRR and LR not only contribute to earnings volatility, but they also contribute to the actual level of earnings. If they didn't, why would banks take these risks?
While FTP should provide a means of quantifying the level of risk-related earnings and clarifying the nature of their volatility, not all FTP processes are designed to function correctly; in fact, very few are.
When FTP is done correctly, IRR and LR is moved from the lending and deposit gathering business units to a central mismatch center. In addition to immunizing these business units against IRR and LR, the earnings associated with IRR and LR is also moved (these earnings represent the cost of hedging the risk). When FTP is not done correctly, the lending and deposit gathering business units are not immunized against IRR and LR and the level of risk-related earnings is miscalculated; this means that some of the earnings in the business units has nothing to do with lending and deposit gathering and everything to do with risks that cannot be controlled by the business units. This, of course, complicates the budgeting and forecasting process as well as capital and compensation management processes which rely upon detail profit measures.
DGA is unique in its belief that FTP can and should bring clarity to the story of how the bank makes money.
At many institutions, FTP is structured so as to reinforce pre-conceived notions of product profitability. Not only is it distorted so as to make most loans and deposits have large, positive spreads, the logic has little or no economic integrity. While this may produce business segment- and product-level margins which make everyone feel good (at least in the short run), these margins are almost certainly unstable because they include earnings that should otherwise be attributed to IRR and LR. If your institution is struggling to make sense of business segment- and product-level earnings, it could be because FTP has failed to remove earnings that should otherwise be attributed to IRR and LR. Worse yet, poorly-constructed FTP methodologies may have actually introduced risk into the earnings measures.
For more information about how DGA can help you develop and implement an FTP framework that has economic integrity, please contact us.