Funds Transfer Pricing in X bank This working paper has been prepared to describe the main principles of setting

fund transfer pricing (FTP) within X bank. FTP is a procedure that creates a matched-maturity cost of funds for all loans and investments and an appropriate matchedmaturity earnings cost for all funding sources, such as deposits and borrowings. In this way, the net interest margins calculated for all business units are comparable and only minimally exposed to unexpected shifts in market interest rates or to changes in the price of liquidity. The core principle is that the managers of the business units should not be held accountable for interest rate- or currency risk if they are not empowered or expected to manage that risk. Background In the broad terms the revenues of any financial institution can be divided into two main areas: net interest income and net non-interest income. Net interest income is the result of interest income (lending and investing into debt instruments) and interest expense (deposit collecting and other funding). For product pricing, risk management and performance measurement reasons it is of critical importance to draw the separation line between lending/investing and funding activities. In the environment of developed and sophisticated money and capital markets this goal is very easy to achieve. Most of the banks in developed markets have credit rating no lower than A/A2. In money market terms this means that these institutions can raise funds at a cost equal to the London Interbank Offered Rate (LIBOR), and also invest their money at the same rate to comparable credit risk. If the bank manages to collect deposits at a rate lower than LIBOR, then positive margin represents the profit for deposit collection. Similarly, if the bank is able to invest money at a higher rate than LIBOR, this margin is the profit from lending activities. Based on the nature of the currency arrangements in all of the three Baltic countries it is obvious that local currency FTP rates for respective maturities cannot under any circumstances fall below the anchor currency (or anchor basket) FTP rates. Latvian lat Unlike excess EEK liquidity, short term excess LVL and LTL liquidity cannot be freely converted into anchor currency and placed into money markets of respective foreign currencies due to regulations imposed by both Latvian and Lithuanian central banks on the commercial banks open FX positions. Thus, the overnight money market in LVL remains active and excess LVL can be placed there at rates close to overnight RIGIBOR or below. We would recommend using 50 bp as safety margin to account for the fact that X bank does not always get the best market rate and also to safeguard from unexpected cash inflows that cannot be handled by liquidity management. Excess overnight LVL liquidity - the unstable part of LVL demand deposits would be priced at a transfer pricing rate equal to overnight RIGIBID minus 50 bp (provided that the rate thus calculated will not result in negative figures, in which case zero is used as FTP rate). The underlying assumption behind the determination of LVL FTP curve is that such rates have to reflect X banks estimated cost for borrowing 10 million LVL under present market conditions. The size of 10 million LVL has important implications herein. It is a hypothetical maximum we can borrow anew (we do not consider restructuring existing borrowings) in the local market. It is called hypothetical because there has not been any benchmark local non-government bond issue of such magnitude before. Larger sizes are impossible because other banks' lines or clients cannot take such amounts if we wish to continue our daily business properly. Why not less than 10 million? The assumption of financing some large project of, e. g., 7m LVL is basic here. Smaller Latvian lat (LVL) has been informally tied to the Special Drawing Right (SDR) since February 1994. With its support activities the Central Bank of Latvia is keeping trading band of lat within the range of +/- 1% 1SDR = 0.7995 LVL. Latvia has a relatively small treasury market (maturities up to 5 years) and a swap market where central bank also participates. Lithuania introduced a full currency board in April 1994. Lithuanian litas (LTL) is pegged to the US Dollar at the rate of 1USD = 4 LTL. Local treasury market is the biggest among the three Baltic countries, and reaches out to 3 years. Still, the liquidity in the market is almost nonexistent and thus this market is not a reliable proxy for reference rates.

Local Currency FTP The definition of local currency in the framework of this document is the national currency of any of the three Baltic countries (Estonian kroon, Latvian lat, and Lithuanian litas). Although all three countries have similar currency arrangements, the state and structure of the money markets differs considerably across the Baltics. Currency board arrangement in Estonia has been in place since June 1992. Kroon (EEK) was initially pegged to German mark at the rate of 1 DEM = 8 EEK. After the introduction of the Euro in January 1999, kroon has been tied to Euro at the rate of 15.64664. Estonia does not have any kind of treasury market. Interest rates are influenced by supply (deposits) and demand (loans) in the cash market and decreasingly also by swap market.

amounts of 3m or 5m could be arranged through money market. In short, we have changed our assumption of FTP as the marginal borrowing rate to the rate pertinent to some size considerations (although it entails pushing the market significantly). For the sake of comparison to the above discussion the size of the daily interbank swap and money market is 10 - 15m LVL. It has a monthly cyclical pattern with increases up to 20m by the end of the month. In addition, three times a week the Bank of Latvia offers 5m LVL in swaps for each of four maturities 7, 28 days and 3, 6 months. Also there is a 2-year swap utility once a month for max 10m LVL. The secondary T-bill market is almost nonexistent with primary focus on reselling the bills to a small number of clients. All the available benchmarks such as debt instruments issued by other banks of comparable rating, the LVL supply and demand in the market, money market short and medium term expectations, etc. are incorporated in setting the rates up to 1 year inclusive. Floating rate LVL Currently X bank as one of the market makers can borrow floating rate LVL at 3m RIGIBOR flat for 3 months and 3m RIGIBOR + 25 bp for 6 months. The size factor (assumption of 10 million LVL) lifts the costs by 25 bp for all these maturities. After 1 year and onwards the fixed margin over the 3m RIGIBOR is determined on one side by the bank's current ability to borrow USD floating rate (LIBOR + X) for certain maturity, to swap the borrowed USD to LVL floating rate (RIGIBOR + X) every 3 months. That way the bank runs FX risk, yet it is the only way to determine the margin above the interest rate indices. On the other hand there are future expectations about convergence to European Monetary Union (EMU) with less arbitrage possibilities from borrowing currencies and swapping them in the local market for lower rates. After 5 years we can assume that with high probability EUR will be replacing LVL. On the practical side, at present there exists a differential of approximately 50 bp meaning if, for example, the bank would borrow floating USD at 6m LIBOR + 50 bp, it could get an equivalent of floating 3m RIGIBOR after swapping USD to LVL in the Bank of Latvia. Taking into account the less-arbitragetrend, the possible EMU and the size factor described above the differential between LVL and USD/EUR fixed margins over floating indices is eroded. Therefore the margin above 3 months RIGIBOR is assumed to be equal to the EUR and USD FTP margins for maturities longer than 1 year. On the whole, the segment from 5 to 10 years must be viewed as very uncertain. To a lesser extent this is true also for 1 up to 5 years, because there is no

underlying currency swap market (except for 3 and 6 months) for the entire 1-10 year segment. Fixed rate LVL The fixed LVL FTP curve can be divided into three segments. The first covers 3 and 6 months maturities. 3m and 6m RIGIBOR + 35 bp are used as fixed LVL FTP, respectively. It is assumed that X bank will be able to borrow fixed rate LVL in the local market at the above rates either by issuing commercial paper or borrowing in the interbank market. As one of the market makers, it would be possible to borrow at RIGIBOR flat, but the size of 10 million has an extra price of 35 bp. Although at the present moment it is possible to borrow indirectly 6-month LVL below 6m RIGIBOR through the Bank of Latvia currency swaps, it is assumed, however, that this advantage may disappear. Therefore the direct cost of borrowing straight from the market is used instead. The second segment of the FTP curve (1 - 5 years) is based on the expectation that the fixed rate can be swapped for floating rate. It must be noted that there is no underlying market and that the bank must search for a counterparty to obtain any applicable benchmark rate. The only valid benchmark is the 2-year USD/LVL swap utility offered by the central bank. To the central banks offered swap rate (currently 6,5%) we would have to add X BANK 2y funding margin in USD plus the size premium of about 25bp. 1-year rate is interpolated between 6-month and 2-year rates based on the availability of counterparties. The second source for determining FTP in this maturity segment would be the rates on Latvian government T-bills. They are compared to the bank's risk relative to that of the government and the fact that bonds issued by X bank would not be accepted for repo deals by the Bank of Latvia. This gives some indication of the fixed rates obtainable for the bank for maturities of 3-5 years. A fact of life is that nobody in the local market is willing to lend fixed LVL to anyone including X bank of maturities longer than 1-2 years. As a result there is no single best answer for the correct fixed FTP rates in LVL. In addition, there has been no benchmark deal on the market thus far. The third segment ranges from 5 years to 10 years. This is the most difficult to determine. An assumption of EMU convergence is used again. The yield curve is basically assumed to be flat, but the liquidity premium to the potential funds provider is added to account for the fact that the investor would want higher return for 10 years than for 5 years. Again, this is a very hypothetical case it would be truly hard (or more likely impossible) to find

someone willing to lend X bank fixed LVL for such maturities. In fact, longer than 5 years curve is not meant to be used for lending unless special occasion occurs. Foreign currency (liquid, OECD country currency) FTP Currently X bank has two main funding sources denominated in foreign currencies deposits and medium- and long-term funding (syndicated- and bilateral loans and debt securities issued to the public). Medium- and long-term funding is an activity over which X BANK has a relatively good control. This means that it is X bank management discretion when and how much to borrow. The price of the borrowing is determined mainly by the state of the international capital markets, and by the creditworthiness of X bank (represented by its foreign currency long-term debt rating). Also there could be (subject to the market conditions) limitations in terms of amount and maturity available. We have learned that deposits (especially demand deposits) are much less manageable. Based on the above we would recommend to use medium- and long-term funding as a proxy for X bank cost of foreign currency funds. As X bank has been active in international capital markets since late 1995 and to this date has done more than 20 transactions, it has established itself as a well-recognised borrower and has created a relatively good understanding of its borrowing cost. The updated and running MTN Programme is also keeping our potential investors active whereby they are continuously forwarding issuance opportunities and posting X BANKs funding levels. In April 2000 X BANK brought its first public bond issue to the market. Euro 150 million 3-year bond is currently the best benchmark for X BANKs external cost of funds. The current X BANKs borrowing cost is presented in Exhibit I. These spreads are presented in basis points (1% / 100) over EURIBOR curve. The same spreads will apply over all other major foreign currency curves (there are minor differences caused by basis-swap market between the LIBOR curves of different currencies, but they are not material and can be ignored). This spread curve represents X BANKs credit risk as seen by international debt investors, and should also be used internally to determine the separation line between deposit taking and loan granting businesses when foreign currency is used. Similarly to local currency deposits also majority of foreign currency nominated deposits collected by X BANK are on demand. Two largest currencies are USD and EUR. Based on the arguments described in relation to EEK we would recommend that USD demand deposits would be priced at the rate of 0.5% lower than FED Funds Target Rate (Reuters page

USFFTARGET=) and Euro demand deposits at the rate of 0.5% lower than ECB Refinancing rate. For the sake of simplicity, all other foreign currencies would be priced also at the Euro rates. Interest rates for foreign currency deposits are set by banks Treasury and approved by ALM Committee. GT is responsible for following and updating X BANKs foreign currency external borrowing rates. Applying FTP FTP rates could be used for a number of different purposes. Unified FTP rates become of critical importance when used for product pricing and performance measurement throughout X bank. For pricing purposes the spot FTP rates should be used. FTP rates used for performance measurement should need some further consideration. Measuring lending In order to understand the true profit from lending and leasing businesses we need to create a fully matched funding for these activities. By doing so we should consider all three dimensions of a loan/leasing portfolio and make calculations accordingly. These three dimensions are - currency, maturity and interest rate. By calculating matched cost of funds for loan and leasing portfolio we are not interested in the actual rate at which the agreement was originally done, but whether this interest rate is fixed or floating. For fixed rate loans we should apply fixed FTP rates but for floating rate loans we should use only X BANKs funding spread applicable for specific maturity. FTP rates are changing on a daily basis. Whenever there is a change in EEK deposit rates or LIBOR rates, FTP rates also change. The average maturity of X BANKs loan portfolio is currently about 3 years. If we would use frequently changing FTP rates to calculate the cost of funds for the loan portfolio, we would expose the loan portfolio to interest rate risk. To avoid this we should use some less volatile FTP rates, which take into account longer time horizon. Although the average maturity of the loan portfolio is about 3 years, the majority of loans get re-priced much more often. 70% of X BANKs (largest lending unit) loan portfolio is nominated in foreign currencies. Apart from loans to HC (additional FTP calculations for X bank are not needed as all the funding has been done based on these rates anyway), almost all loans are floating rate based and get re-priced at least after every 6 months. Remaining 30% of the loan portfolio is nominated in EEK, and the rates on most of the loans in this portfolio are tied to X bankbanks Prime Rate. Prime Rate is re-priced annually. Also we have learned that if there is a significant drop in interest rates, a considerable number of our customers are looking to re-price their loans. In a competitive environment this is also mostly done.

If about 65% of loans are re-priced semi-annually and 25% annually, then the average duration (interest rate sensitivity) of the loan portfolio is around 6 months. To reduce timing distortions between loan portfolio and FTP rates we would recommend to use 6 months moving average FTP rates. The average would be calculated based on the FTP rates effective on the last banking days of the last 6 months. Measuring deposit taking The majority of deposits collected across X BANK are on demand (please see Exhibit II). Demand deposits could be defined as funds, which depositors could withdraw within 48 hours. Still, treating all demand deposits as 48 hours funds would clearly undermine their true maturity profile. Being the cheapest source of funds, demand deposits have proved to be also relatively stable on the portfolio level. Since the start of X BANKs operation in 1992 there have been only few months where the amount of demand deposits has decreased. Furthermore, this decrease has never occurred in two consecutive months. We could make a judgement that with relatively high probability some part of the demand deposit portfolio has a longer maturity than just overnight. To capture that knowledge we would recommend to find how big a part of the demand deposits portfolio has been stable over the last 12, 6 and 3 months. In measuring the performance of deposit collecting we would apply the 12, 6, and 3 months FTP rates (6 months average) to the respective parts of the deposit portfolio. Summary 1. LVL FTP curve is built on overnight RIGIBID, RIGIBOR rates, X banks international funding spread and LVL risk margin