This article continues the previous discussion of bank net interest margins. In it, I discussed how changes in the yield curve changed the net interest margin (NIM) for banks. This showed up historically — when bank balance sheets were shattered by the combination of holding long-dated mortgages with low fixed coupons versus having a sky-high short-term rate imposed by deranged Monetarists. In this article, I address a common macroeconomic story: yield curve inversions
In my opinion, most bank Transfer Pricing (TP) mechanisms tend to penalise the lending unit. A $50 million loan requires about 12% ($6 million) in capital. So lending unit should only borrow 50-6 = 44 from Treasury at TP rate, instead of borrowing 50. But most banks do charge on the 50, and then they calculate the lending unit's income (reduce by TP interest on the extra 6) as a percent of economic risk capital. Thus lending unit's performance is penalised. Economic balance sheet of lending unit: Assets: 50 Loan; Claims: 44 TP loan and 6 in capital. Squeezed lending unit income provides lower return on economic capital.
I agree liquidity risk has been mis-priced in most TP systems. Even the banks that have been trying to charge for liquidity risk have had trouble coming up with reliable figures. Of course there is also the optionality cost of Treasury offering a TP rate lock today for a loan that may or may not be accepted and close in a few weeks.
However, I believe most banks do not use variable TP rates for loan quality decisions (some differentiate on type of loan businesses, eg commercial loans versus prime loans to hedge funds) but rather have credit risk and returns assigned to lending unit.
I agree with your conclusion about inverted yield curve not causing bank losses but rather influencing fear in potential for credit downturns and possibly leading to tightening lending standards.
In my opinion, most bank Transfer Pricing (TP) mechanisms tend to penalise the lending unit. A $50 million loan requires about 12% ($6 million) in capital. So lending unit should only borrow 50-6 = 44 from Treasury at TP rate, instead of borrowing 50. But most banks do charge on the 50, and then they calculate the lending unit's income (reduce by TP interest on the extra 6) as a percent of economic risk capital. Thus lending unit's performance is penalised. Economic balance sheet of lending unit: Assets: 50 Loan; Claims: 44 TP loan and 6 in capital. Squeezed lending unit income provides lower return on economic capital.
I agree liquidity risk has been mis-priced in most TP systems. Even the banks that have been trying to charge for liquidity risk have had trouble coming up with reliable figures. Of course there is also the optionality cost of Treasury offering a TP rate lock today for a loan that may or may not be accepted and close in a few weeks.
However, I believe most banks do not use variable TP rates for loan quality decisions (some differentiate on type of loan businesses, eg commercial loans versus prime loans to hedge funds) but rather have credit risk and returns assigned to lending unit.
I agree with your conclusion about inverted yield curve not causing bank losses but rather influencing fear in potential for credit downturns and possibly leading to tightening lending standards.