by Leonardo Orlando
Last time we explained how Treasury role can become crucial in the portfolio management, highlighting the four main pillars where it can provide its value.
- A. Business Decision Making Support
- B. Liquidity & Funding Optimisation
- C. Asset & Liability Management Optimisation
- D. Capital Management Optimisation
This article will provide an high level view of how Treasury can proactively contribute to the balance Sheet Effectiveness.
In 2007 Financial crisis has raised concern around the availability of liquidity in the market, since such as waterfall effect it had directly determined the overall system default. As a consequence Regulator has introduced more challenging requirements, making liquidity a more costly resource.
Now, since Treasury core activity inside banks organisation is to fund Business in a “correct” manner, related funding cost needs to be measured and then attributed to Business Units. This cost is called Liquidity Risk Transfer Pricing (LRTP) and has to reflect the cost for Treasury to face not only to the liquidity cost itself but also to the cost of covering a potential risk of unexpected cash flows.
LRTP will then become the major measure for Business to monitor and control their usage of central Treasury resources and through a transparent information flow (from Treasury to Front Office), Business will be able to implement an easy and straightforward Scenario Analysis to forecast the portfolio impact on liquidity risk cost and then on the Business Unit risk adjusted profitability itself.
There are different management theories on how the LRTP may affect Business and one of those shows how LRTP can be embedded in the portfolio pricing, then not impacting the return on capital but affecting the overall pricing model. An other theory, opposite to the former illustrated before, shows how LRTP should not reshape the pricing model of the bank, otherwise it would reflect any Treasury inefficiency in the portfolio pricing, creating room for market arbitrage.
Having said that, Treasury is in any case ultimately responsible for the LRTP and its impact on portfolio optimisation so Treasury efficiency will be directly reflected into a more effective Balance Sheet management.
In the next article we will give a much more understanding of Treasury contribution to the Balance Sheet Effectiveness.