Funds Transfer Pricing

INTRODUCTION

As mentioned earlier, funds transfer pricing, or FTP, is the process of using market rates to value fund using and fund providing products (loans, deposits, etc.) independently of each other. Imagine funding or investing each customer account separately (or other balance sheet item, but more on that later). That is essentially the task of FTP.

One of our consultants uses a cash register analogy: Imagine adding a new fixed rate loan to your balance sheet. During FTP processing, the FTP system calculates the funds charge for that loan based on its maturity characteristics. Every quarter, because interest rate risk is reported separately, the cash register rings for that branch or product in the amount that loan’s rate is above the comparable wholesale rate. Similarly, deposits receive a funds credit and their spread is the amount their rate is below the comparable wholesale rate.

There are two main benefits to using market rates. By using them, business units do not enjoy or pay for:
 

1. Efficiencies or inefficiencies in other units
2. Interest rate risk the bank may assume as a matter of Asset/Liability Management policy

The traditional way of evaluating a lending area is to consider the institution’s cost of funds as determined by its average interest expense rate. Lenders seem to like this because they generally view it to be a “hard” number. If the branch network grows progressively less efficient, however, the lenders’ profitability trend will worsen without any action on their part. Also, as we all know, costs of funds can change rapidly. This should not affect the profitability of a well-priced loan put on the books in different market conditions.

The difference between the funds charges and funds credits is generally called the maturity gap or mismatch. By isolating this mismatch in a treasury area, it becomes easier to evaluate how well the FTP system represents the interest rate risk the bank has assumed. It should generally agree with the output of an Asset/Liability Management application and adds to the credibility of the reporting.

As a demonstration, consider a hypothetical bank with two accounts: a five year loan and a two year certificate of deposit for the same amount, originated on the same day, with the following wholesale rates available for the institution on that day:  

WHOLESALE RATES

The resulting income statement for the bank (expressed as rates) appears as follows:

While the rates on these accounts are arbitrary and deposits could be the real money maker in a different scenario, this example shows several useful things, among them:

1. The institution could borrow money from the wholesale market more favorably than it could raise money through CDs.
2. It is making almost as much money from assuming interest rate risk as it does from the lending function itself. This should be evaluated.

A possible result of the evaluation is that the loan may prepay and therefore the bank may not be taking on as much risk as appears in this analysis. Also, the deposits may be checking accounts and have indeterminate maturity characteristics. Different FTP methods have arisen to accommodate these issues.

FTP METHODS

There are three main methods used in funds transfer pricing. They are:

1. Coterminous (sometimes known as matched maturity)
2. Cash flow
3. Blended rates (sometimes known as pool rates)

COTERMINOUS

Sometimes referred to as “matched maturity” funds transfer pricing, this method is the hallmark of funds transfer pricing and is probably the one least subject to the variability of assumptions. Essentially, the funds transfer rate (either credit or charge) is set by finding the wholesale rate of the customer account’s term on the day that the account was either originated or the interest rate changed according to some schedule. For example, a two year CD originated today gets the two year wholesale rate.

Since the purpose of FTP is to calculate funding costs or alternative investment opportunities, however, for something like an adjustable rate mortgage (ARM), the origination and maturity dates would not be appropriate. In this case, the treasurer funds the ARM from the date the interest rate changed last to the date the interest rate will change next. These are called repricing dates and serve as the FTP term. A one-year arm would get the one year rate on the day that the interest rate changes.

CASH FLOW

The coterminous method does not account for products that generate cash flow, however. In the case of amortizing loans, like residential mortgages, the FTP rate has to accommodate the fact that principal can, and usually does, come back early. Some kind of adjustment to the FTP term has to be made to accommodate this, not unlike a duration calculation. Typically, different proportions of the principal are funded at terms appropriate to the speed at which principal will probably return.

It is easy to take the duration concept too far, however. FTP models that are so complex that only one person in the institution can understand them will probably mean that only one person in the institution will accept them.

We try to use the old rule: keep it short and simple. Of course, a good information system will provide an audit trail. It is important to strike an appropriate balance, but in general, a reasonable assumption consistently applied is better than a precise and unprovable calculation

BLENDED RATES

Speaking of reasonable assumptions, we arrive at the final FTP method, that of blended or pool rates. The most common method uses a rolling average of interest rates at a specific term. Blended rates, typically used for non-maturing deposits like checking and savings, are combinations of different terms.

The duration of non-maturing deposits is the subject of hot debate in the Asset/Liability Management community (as hot as it gets, anyway…) Some point out, probably quite rightly, that deposit accounts hang around for longer than you might think. The key is to have assumptions that managers agree reflect the character of your institution.

Balance sheet items that need a funds credit or funds charge but have no records that can be coterminously transfer priced also traditionally get pool priced. For example, branch cash typically gets a funds charge at an overnight rate. Balances not on the bank’s core processing system, certain types of leases for example, also frequently receive a rolling average pool rate.

Different opinions exist concerning so-called Other Assets and Liabilities. Accruals and prepaid items typically exist in operational centers. Those centers are typically allocated, so having interest income and expense there tends to add complexity for little additional insight. Of course, some point out that all bank operations must be financed and therefore argue for transfer pricing the entire balance sheet. Here again, bank management must agree on what makes sense for their institution.