The terminology describing each of these parties is overwhelmingly important. For our example we have one bidder, or arranger, five lead managers and two managers.
Upfront fees will include an underwriting and participation fee; we have used typical values of 10 and 25 bps, respectively, on the loan notional. These are payable to the relevant members of the syndicate depending on their status. For example, the two managers will not receive an underwriting fee. This syndication strategy typically gener- ates 5 bps extra for the bidder, the so-called praecipium, as recom- pense for both organizing the deal and taking exposure to market risk. In this example, the total upfront fees paid by the borrower are 40 basis points which is equivalent to €2.0 million comprising the prae- cipium, underwriting and participation fees.
The yield has to be determined from each of the party’s perspective.
For example, the praecipium will be removed from the total fee and the remainder divided by the loan notional in order to determine the yield relevant to the arranger and lead managers. The flat yield is obviously different for each of the banks and is found in each case by dividing the total fees for each category by the amount of loan participation.
the treasury, which raises debt or invests excesses within the external marketplace. We can conceptually think of this arrangement as a central pool of funds where the pricing policy is only partially determined by the capital markets. The FTP actually sets the price with the weight towards commercial considerations.
The FTP system has two sources of funds: internal-business units and the external marketplace. Usually debt financing is arranged (equity is too expensive). The margin the bank adds to the internal-funding cost is known as the commercial margin. It is applicable to internal-business units and promoted through the FTP. This mechanism can be thought of as the ‘internal market’ accessed by the business units.
There are differences between borrowing in the ‘internal market’ and the ‘real market’. The transfer prices should be consistent with commercial policy.
Transfer prices then are subject to both. A correct price will ensure that funding constraints partly determine the transfer price. The main driver however, will be the commercial aspect of the company. The business might actually decide to subsidize the customer if that policy is in line with the core strategy. In normal market conditions however, business units extending loans at non-commercial spreads will dis- cover over time a lack of internal funding. (Too high and there will be a lack of customers.)
The treasury will be responsible for minimizing the cost of funding.
There can be some variation in how this policy is actually executed in practice. This is a consequence of the opportunity cost arising from a potential gain in a beneficial market movement. This would be neu- tralized by any systematic hedging policy. The treasury should nor- mally operate as a cost centre but will be held responsible for any resulting saving in the cost of funds obtained through underhedging.
Equity
FTP Business units
Debt financing Capital markets
Figure 2.4 The FTP mechanism.
There are slight complications surrounding the fact that interest rates have a term structure. This means that a system based upon one transfer price equal to the average cost of funds would be inefficient because the funding will be higher for longer-dated commitments. The upshot is that transfer prices are differentiated according to maturity.
We demonstrate the build up of a commercial margin with an example;
in general the overall or accounting margin applicable to the entire busi- ness is defined as
Consider a commercial bank with the balance sheet displayed (Table 2.3).
The overall accounting margin will be
Stating that the assets return 14 per cent and the liabilities are composed of equities and debt with costs of 12 and 4 per cent respect- ively, we can also get to the accounting margin in terms of a sum of FTP and commercial margins. The commercial margin is
This margin is relevant to internal-business units which have access to the equity but do not have access to external financing. They can how- ever access the FTP as a supplier and purchaser of funds. The FTP can be thought of as the adjustment to the commercial margin in order to equal the accounting margin.
Thus to balance the equation we add the FTP margin, which is the relevant calculation for the non-equity funding:
$4000 M (6 4%) $80 M.
$7000 M (14 6%) $3000 M (6 12%) $380 M.
$7000 M 14% $3000 M 12% $4000 M 4% $460 M.
Marginaccounting Margincommercial MarginFTP. Table 2.3 The costs and charges.
Balance sheet Rates (%)
Assets $7000 M Cost of equity 12
Liabilities $4000 M Charge to customers 14
Equity $3000 M Internal transfer price of resources 6 Internal transfer price of funds 6
Market funding rate 4
Conversely we tend to start out knowing the transfer price, built up from the factors displayed in Table 2.4 and furthermore an acceptable return on equity. How do we determine the customer rate?
Consider an example whereby the bank wishes to secure a 25 per cent return on equity, the accounting margin must be set at $750 million.
This can also be written as the difference between the revenues and the cost of funds:
This gives a customer rate of 18.1 per cent which translates into a margin of 12.1 per cent for the individual business units (18.16 per cent).