Prudential Regulation Authority Rulebook

1.

Theoretically, assuming a society is wholly retail funded and uses a marginal rather than blended historic cost approach, the potential building blocks of its ‘cost of funds’ calculation would include, but not necessarily be limited to:

1. (a) a ‘benchmark rate’ that its board believes (based on historical evidence) to be the main driver of changes in its core retail cost of funds (eg bank rate, SONIA);
2. (b) a ‘market spread’ that the society considers it would need to pay above or below (a) to generate core instant access retail funds at the time of pricing eg through its branch network if this represents the source of the majority of its deposits by value. The same spread could be used for all savings products. The society would need to understand how its market spread compares to that of others against which it competes for funding, bearing in mind that the overall price of competitors’ products includes their own liquidity, and hedging costs (so their market spread would need to be estimated net of these costs);
3. (c) a positive or negative adjustment to (b) above based on the society’s assumptions and/or expectations for future widening or tightening of the spread used in the corporate plan covering the period over which the product is being priced;
4. (d) for fixed rate products, an adjustment representing the difference between the benchmark rate and the relevant swap rate, adjusted for any premium or discount required to offset basis risk mismatch being incurred as a result of offering the product (ie the cost/benefit of changing the society’s overall basis mismatch position);
5. (e) a ‘term liquidity premium’ (TLP - Savings) to represent the amount that the society is willing/needs to pay for longer term and/or more stable funding. The TLP may be nil for instant access funding that is transactional, but potentially higher for instant access balances that display longer behavioural maturities (ie where the society would be prepared to pay higher rates to attract instant access balances that are stable - eg some ISA balances - leading potentially to a lower liquidity requirement for these balances). Similarly, for longer term fixed rate funding the board may wish to recognise, in its pricing approach, that liquidity would not need to be held against the liability until the residual contractual period is within its liquidity stress period as defined for its OLAR; and
6. (f) an estimate of the different operating costs of various channels versus the core instant access channel (eg internet and postal channels may be cheaper to operate than the branch channel, justifying an appropriate rate adjustment).

2.

The aim of developing such a methodology would be to arrive at a cost of funding across all products such that, from a cost perspective alone, the society is indifferent to which product savers actually prefer to take at any given time. Where the adjustments to the core funding cost for all savings products in the range simply reflect the incentives/disincentives to the saver to accept varying product features, the society can use the core funding cost as an input to pricing its mortgage products.

3.

However, there are considerations other than price that affect the choice of funding approaches such as liquidity optimisation, NSFR (choosing to target more stable funding than the minimum) and basis risk. The extent to which these can be factored into a pricing model will depend upon the scale and complexity of a society’s business.

4.

In addition to core funding costs, societies need to consider the impact on pricing of lending of other relevant cost elements. Theoretically the key elements of ‘loan pricing’ are:

1. (a) a ‘liquidity holding premium’ (‘LHP’): the costs of holding additional liquidity in support of the additional funding (given that new lending requires new funding, which in turn generates a requirement to hold additional liquid assets, reducing the amount of the new funding that is available for lending), and that those new liquid assets may earn a coupon less than the cost of funding – therefore reducing earned margin;
2. (b) the ‘loan pipeline liquidity cost’: the cost of holding liquidity against anticipated new lending drawdowns;
3. (c) the revenues and costs arising from fees (eg cash backs or arrangement fees) and commissions (eg broker commissions);
4. (d) the operational costs associated with originating and servicing the new lending and raising and administering core funding;
5. (e) any direct statutory or regulatory costs eg FSCS levy;
6. (f) the capital cost associated with new risk assets (ie the expected loss, as a margin component);
7. (g) hedging costs associated with managing interest rate risk, basis risk or currency risk arising from the loans (including settlement and clearing house initial and/or variation margin costs); and
8. (h) the premium needed to achieve the society’s target return on capital. A society may wish to take into account its target solvency/leverage ratio, its planned growth and the earnings on free reserves in determining its return on capital requirement.

5.

Applied to the treasury approaches, the relevant components that societies would model are set out in the following table: