Originally Posted by Timing belt
If it is a fixed rate mortgage there should be no basis risk unless the bank decided to run a unmatched book and if it does then the risk should be covered by its interest rate risk policy.
Any liquidity cost should be accounted for and allocated appropriately at a product level along with the operating costs of the business and the credit risk premium when setting the Margin for the loan.
The reason Ulster bank are not making money is mainly down to the capital it needs to hold because of the risks they took back in 07/08 and because they don't have the volume to remain profitable for their operating model. The alterative would be to invest in the operating model to make it more low cost and streamlined but Natwest obviously thought that this was not worth the investment and the funds could be used better elsewhere in the Bank.
All valid points...in theory. Have little to do with reality. The reason UL is not making money is not Capital costs. Capital allocation is merely ineffective, as they'd rather deploy that capital in the UK where they can get a better return. They're not 'losing' money per se by holding capital, just missing out on making more money.
The reason UL are losing money is tracker mortgages and the cost of remaining competitive (it costs and lower rates) which (trackers) leads to my initial point about basis risk. Banks don't really price basis risk at facility level, so if you've basis risk in trackers due to inability to adjust their pricing in line with real costs, you've basis risk on the entire book. You try to mitigate it with new lending, but will not eliminate it until trackers are off the book fully.
I don't really understand your point on product level allocation of risk? What if you mispriced it previously? Does it just disappear or do you think banks try to recover it's costs by other means for the backbook?