Sentido de iniciativa y espíritu emprendedor (SIE)

Introducing Credit Transfer Pricing, principally with regard to loans to large companies, represents another attempt to identify the economic value of loan transactions more objectively. Credit Transfer Pricing is an internal process that reflects credit market views in loan origination and plays an essential role in US- and European-style CPM. More specifically, (1) it transfers loan ownership from the marketing division to the CPM department24_{, and (2) it sets the transfer price based on the credit market price (or a}

theoretical price calculated rationally using credit market parameters). The Credit Transfer Pricing Mechanism25

24 If we envisage a framework for transferring the ownership of all loans to large companies from the marketing department in the future, one issue to be studied is that of detaching intermediate monitoring functions such as the assignment of internal ratings from the marketing division. In such cases, one option is that the CPM department could engage in intermediate monitoring only if the internal rule of handling nonpublic information is set in force. Another option is that a department other than the CPM department could be established to deal with assigning and reviewing internal ratings.

Funds for risk hedge 20bp Gain 0bp Company A Gain 10bp

[Business management unit]

CDS market [Shareholders] Gain 10bp Transfer price L+30bp <Risk hedge> <Origination>

[Marketing division] [CPM department]

EL portion 20bp

Capital cost portion 10bp Execute loan

L+50bp CDS premium_20bp

Protection

Capital cost portion 10bp Expenses 10bp

(a) Marketing department pursues a loan deal to company A.

(b) Reflecting the evaluation of a neutral division within the organization, the transfer price is set at, for example, L+30bp on the basis of company A's credit cost (EL=20bp) and capital cost (single-name UL x capital cost ratio=10bp)26_.

― The transfer price may be determined on the basis of company A's credit spread (hedge cost) in the case where such spread information is available in the credit market27_.

(c) Taking the above-mentioned transfer price into consideration, the marketing division extends the loan to company A at L+50bp.

(d) The marketing division recognizes a gain of 10bp after the transfer price portion (30bp) and expenses (10bp).

(e) The CPM department uses the 20bp remaining after deducting the capital cost portion of 10bp from the 30bp transferred from the marketing division as funds for the risk hedge transaction.

― If the risk premium paid for the risk hedge transaction in the credit market is 20bp, the CPM department's gain is zero.

― If, on the other hand, the CPM department manages to hedge company A's risk at a risk premium of 15bp in a timely manner, the 5bp difference is recognized as a gain for the CPM department. Conversely, if it has no choice but to hedge the risk at 25bp, the difference of minus 5bp is recognized as a loss28_.

(f) The 10bp capital cost portion is returned to shareholders (or kept as retained earnings).

If this type of Credit Transfer Pricing mechanism functions properly, it clearly distinguishes the role of the marketing department, which extends the loan at appropriate

26 The level of the transfer price would greatly affect both the breakeven assessment for the marketing department's loan origination and the breakeven assessment for the CPM department's risk hedge. For this reason, it is necessary to have a framework whereby a department that is independent of both the marketing division and the CPM department (such as the risk management division) assesses the appropriateness of the transfer price.

27 US and European financial institutions mainly determine the transfer price on the basis of the borrower's credit spread as observed in the credit market.

28 If company A defaults before the CPM department can hedge the risk, the CPM department has to bear the loss.

pricing, from that of the CPM department, which manages credit risk in an integrated manner. At the same time, it provides both with the incentive to increase their returns.

(1) Earnings-enhancement incentives for the marketing division

Normally, the loan margins offered by Japanese financial institutions are ultimately determined with the credit division's participation and in accordance with ratings-specific spread guidelines. From the perspective of sound economic reasoning, it cannot be denied that in such cases ambiguities may remain in the guideline spread and the final decision process.

With Credit Transfer Pricing, on the other hand, the costs charged on the loan funds are based on economic rationality. If the marketing division extends a loan with margins that do not match these costs, it will incur a loss for which it will be accountable to management. Consequently, the marketing division has the incentive to (1) extend loans with margins that exceed these charges29_{, and (2) expand its fee and}

commissions business30_.

(2) Earnings-enhancement incentives for the CPM department

As mentioned earlier, the CPM departments of major banks are normally in deficit because they have to bear the cost of risk hedges in the face of limited gains on risk-taking.

With Credit Transfer Pricing, the CPM department acquires a portion of the loan spread commensurate with the rationally calculated credit costs. As a result, the gain/loss on the risk hedge can be plus or minus depending on whether this portion is large or small compared with the risk premium demanded by the market. Based on this mechanism, the CPM department does not simply hedge against risk, but has the incentive to increase its own returns on the same risk hedge by skillfully choosing its timing and its counterparties as a means of lowering costs31_.

This means that the CPM department is no longer a cost center within the

29 If capital costs equivalent to credit concentration risk are charged, this functions as an incentive to curb lending to large borrowers.

30 The marketing division is free to make overall judgments that allow it to set low interest rates but make up the shortfall through commissions. The key point is that using the transfer price as a basis makes it possible to clarify whether overall profitability, which is prone to ambiguity

organization but is transformed into a profit center that is expected to post gains from market transactions. It probably marks the first step towards the type of CPM practiced by some leading financial institutions in the US and Europe, whereby the CPM department posts gains while taking on risk exposures of its own by, for example, purchasing what it believes to be undervalued credit risks from the market.

Whether Credit Transfer Pricing functions well or not depends to a large extent on the manner in which transfer prices are determined. Given that the Japanese credit market is still underdeveloped today, there are probably many cases where the transfer price has to be set at the theoretical price obtained using the EL/UL buildup approach. However, it is probably more meticulous organization-wide discussion on the economic value of loans that will lay the groundwork for the development of the credit market.