Branch funding policy
Category: Branches
1. Funding in banks
Discuss briefly how are financed branches in trainees’ banks.
Make sure that allocation of responsibilities between branches and head office is consistent with the business that branches are expected to do, and what they are not supposed to do.
This means there must be a clear awareness of this at both levels. If this is not clear, a deep thinking effort and clear decisions need to be made in the first place.
Basically, the business of a branch is unique: sell products. In fact, all banking services can be accounted for as products.
Branches are not suited to manage a number of risks that naturally arise from their commercial activity: interest rate, currency and liquidity risks. They are generated from branches’ lending and deposit business, broken down by currency, maturity and type/level of interest rate.
This management belongs to the field of responsibility of the Asset & Liability Management team of the head office.
Asset & Liability Management (ALM): defined as the unit at head office that centrally monitors the equilibrium of the overall balance sheet, and who is in charge of issuing directives on the financial policy. ALM is most often steered by an ALM Committee (ALCO) and the Treasury Department is its most logical executive arm.
2. Branches are salespoints
Repeat that branch have a unique job: selling.
Deposits collected by branches belong to the entire bank: they make up the total deposit amount that the bank collects and their use has no connection, at branch level, with the level of credit.
This means that branches are not limited by their total deposit in their ability to sell credit. The overall lending level has no upper limit in absolute terms. The only limitation in credit is linked with the client’s borrowing profile and credit pricing. If lending exceeds deposits, it is the duty of the Treasury Department to raise extra resources.
3. Physical and notional circulation of money
Make sure that everybody understands the difference between scriptural money circulation (notional), by bookwriting, and physical money transfer.
Choice between physical and notional money transfer is a matter of internal policy for every bank. It mainly depends on the distance between the branch and the regional or the head office, especially if money transfer has to be done in cash.
The notional money transfer to head office should anyway be systematic, on a periodicity that depends on the business volume.
4. The money wasting scenario
This describes what often happens in banks in Russia and other countries. The treasury function in each branch can negotiate assets and liabilities with other branches, or headquarters, upon their own choice.
This model is based on the assumption that a branch is unable to grant more credit than it has obtained as savings, and funding is not always centralised at head office level. Therefore branches with excess savings may deal with others with excess credit. This is at the origin of a vicious circle since treasury deals between branches may develop without any customer transactions.
If no counterpart wishes to deal with a branch which is short on savings, it may suspend lending if no counterpart is found.
5. The virtuous circle to implement
Branches have to eliminate funding problems by only dealing with one counterpart: bank’s Treasury Department.
Treasury Department must keep in control of refinancing conditions. There we will depict how Treasury Department operates with branches and any profit center.
Note that the notion of profit center will be examined in the “efficiency management” module.
6. Various treasury management methods
Single treasury pool method
The simplest way: all types of liabilities fund all types of assets, all together. It can consist of gross money flows or net flows .
Multiple treasury pool method
Explain that there is a possibility of improving the adequacy of treasury flows by this method. It consists in matching similar types of assets and liabilities. This is under the responsibility of the Treasury Department.
The choice among treasury procedures by each individual bank depends on how active the Treasury department wants to be in funding the bank, and how well organised and how well equipped they are in terms of treasury management tools. It also depends on the quality of the people at treasury level.
Managing gross or net flows
Similarly to the previous, this one emphasises the role the treasury wants to plays and the level of detail that the bank wishes to manage.
7. Constituents of pricing
Examine all components that make up a price
The previous examination leads to introduce the components of pricing by a branch. On this the components of the interest rate of a loan is detailed:
The refinancing rate is the gross cost of the resource. It is increased by the “risk premium” on the liability (financial risk)
The quote-part of general expenses allocated to the profit center is added
The cost of embedded options and the financial risk on assets is then added. The cost of embedded options is the hidden cost for the bank of possibilities given to customers. For example, prepaying a loan before maturity has a cost in interest that the bank will not receive.
Finally, the commercial margin is the added value of the branch and is set by the branch itself.
Often, banks that have an orderly cost breakdown end up with a total interest rate, which may be higher than that from competition. The final price, which will be applied to the customer, can then be a compromise to avoid showing too much difference with competition.
What to do when decision is made to price below cost?
A matter of responsibility in fixing interest rates needs to be clearly expressed. The adjustment of interest rate (the commercial compromise) which is negotiated between the branch and the customer has an impact on the branch’s profit & loss account.
However a branch may be required to operate in an area where business is not profitable. It can be the case when opening one in a place to be in touch with one single large customer. In such a case, the head office is responsible for this situation and it therefore has to bear the cost of the situation on its own profit & loss account. This means the branch is funded by an adequate transfer from the head office.