Funds Transfer Pricing – Methods and Benefits

Funds Transfer Pricing (FTP) is an important management accounting technique used by Banks. The primary objective of FTP mechanism is to assess Bank’s profitability at micro level and establish the formal mechanism for asset pricing with due weightage on liquidity risk. FTP provides critical strategic input to the management to take decisions with respect to expanding or scaling down business segment/ product/customer segment.

Objectives of FTP

Emergence of liquidity risk during 2008 Global Financial Crisis (GFC) led to the wide use of FTP mechanism among Banks. In the pre-crisis world, the liquidity risk was taken for granted as abundant liquidity was always present. However, during the crisis this assumption turned faulty. This led to deposit runs, credit crunch, rise in cost of funds, defaults, fire-sale of assets to raise liquidity etc. Thus, liquidity became scarce and costly. Few financial institutions collapsed and many severely impacted.

Further, it was noted that not only liquidity and interest rate risk (IRR) were not effectively managed by Banks but also not considered for the asset pricing. This led to mispricing for many lending transactions as the required costs were not passed to the lending units. Also, the borrowing units were not given their due benefits based on the funding mix. Hence, the need to assess and pass on the required costs, benefits and risks to the business units emerged strongly in the post crisis world.

FTP mechanism attempts to adequately address these risks within the Bank along with appropriate asset pricing based on the liquidity costs across different maturities.

Traditionally, Banks measure their profitability based on several matrices. These include Net Interest Income (NII), Net Interest Margin (NIM), Return on Assets (ROA) and Return on Equity (ROE). Though these matrices are important, they fail to provide micro level view of the profitability. For example, the profitability of the Branch/Region/Zone or Business Vertical/Segment/Product/Customer cannot be assessed from these matrices. The assessment of profitability at granular level is essential to understand the profitable branches, segments, products, customers or relationship managers. This will act as a strategic input to the senior management to take various business decisions with respect to expansion, scaling down, incentive structures, customer relationships etc. This becomes more important considering the increasing competition, regulations and increasing regulatory capital requirements.

FTP ensures the necessary costs and benefits are allocated to the respective business units, products and transaction, enabling objectivity in performance monitoring along with granularity.

FTP Mechanism – How It Works?

Banks are in the business of borrowing and lending. They incur interest costs on the borrowed funds (Cost of Funds (CoF)) and they earn interest income on the lending (Yield). Banks typically borrow short term funds and lend for long term assets. This is called maturity transformation where the short maturity liabilities are transformed into long maturity assets. This typical business structure leads to different risks to Bank. The lending segment generates credit risk for Bank and the borrowing activities leads to liquidity risk and IRR. The profitability every asset created through lending transaction is subject to the behaviour of these risks till the life of the asset.

Bank may do good on the credit risk side but may get hurt from the volatility in the interest rates or lack of funding due to credit crunch in the market. At other times, exactly opposite scenario can emerge. Hence, profitability of the Bank is subject to the management of these risks. FTP mechanism ensures the onus of risks are apportioned to the right risk owners and adequately considered during transaction level pricing.

Under FTP mechanism, Bank is divided into three segments, viz., liquidity generators, liquidity users and Central Funding Unit (CFU). Liquidity generators raise funds from the market in the form of deposits or debt (Example, Branch accepting deposits from customers). Liquidity users lend funds to the retail and corporate customers also invests the money in different financial instruments (Example, Home Loan or Personal Loan division of Bank). CFU is made responsible to handle maturity mismatches (which leads to liquidity risk) and IRR. CFU generally forms part of the Treasury/ ALM division of Bank.

The funds raised by liquidity generators are notionally transferred to the CFU at the Transfer Pricing (TP) rate (will be discussed shortly). The funds received by CFU are in turn notionally transferred to the liquidity users for onward lending at TP rate. TP rate received by liquidity generators is known as transfer credit and the TP rate paid by the liquidity users is known as TP charge.

The profitability of the liquidity generators is the difference between TP credit and CoF whereas the profits of the liquidity users are simply the difference between the Yield and TP charge paid. CFU profits are difference between the TP charge and TP credit.

FTP mechanism ensures centralization of liquidity risk and IRR in the CFU of the Bank. CFU takes the responsibility of these risks and relieves the business segments (both assets and liabilities) from the possible stress caused in the profitability due to constant changes in the liquidity conditions and interest rates. This model ensures that spreads of business units are protected from the inception of the transaction. The risk of possible fluctuation in the spread due to changes in the liquidity and interest rates in future are assumed by the CFU. Hence, business segments are relieved from unnecessary stress and thus can focus on their core business strength.

How TP Rates Are Determined?

Determination of TP rates is the crucial component of the FTP mechanism. If these are not determined with proper methodology and rationale then the whole purpose of the FTP will fail. The TP rates for liquidity generators (TP credit) and liquidity users (TP charge) are different. The steps involved in determining TP rate include identification of appropriate market benchmark and adjustment to the rates by relevant market/internal factors.

1. TP Rate for Liquidity Generators

The concept of opportunity cost is applied to determine this rate. For example, if a Branch would not have raised funds from the depositors (say @3%), then the Bank would have had required to raise the funds from the money market at the prevailing rates (say@5%). These money market rates are used by CFU to determine TP rates to be credited to liability unit.

In money market, the benchmark rate for short term funding (up to 1 year) is MIBOR. In case of funding in foreign currency, the benchmark rate is LIBOR. If the funding is medium to long term then G-Sec Yield for the equivalent maturity can be used as benchmark. Bank can select appropriate benchmarks based on its liability profile and credit rating. It may use single benchmark or average of two benchmark. For example, Bank may use average for MIBOR and T-Bill rates for determining TP rate for 3-month Fixed Deposit raised by Branch.

Further, the funds mobilized by liquidity generators have different maturity profiles. Apart from short term and long-term maturities, the nature of maturities may differ based on the funding source. For example, Fixed Deposits have contractual maturity but CASA does not have any fixed maturity as customer can withdraw money at any time. Hence, to arrive at the TP rate, adequate consideration of the behavioural pattern of the funding source is imperative.

Thus, the TP rate for the liquidity generators is determined based on the appropriate benchmark available in the money market and the maturity profile of the funding source.

2. TP Rate for Liquidity Users & Key Adjustments

Determination of TP rates for assets units requires some adjustments to the TP rate determined for liquidity generators. These adjustments include negative carry for the CRR/SLR maintenance, costs incurred for maintaining liquidity cushion, embedded optionality in terms of prepayment of loans and liquidity premium. Let’s understand them one by one:

These are important adjustments that are performed to determine the TP rate to be charged to liquidity users. Here, we should note that the adjustments discussed above for both TP credit and TP charge are not exhaustive. Bank may have additional adjustments based on the rates offered by competition, economic outlook, desired funding/asset profile, repricing frequency, basis risk, transaction costs etc.

Further, these adjustments can result in either positive or negative margins to be added or subtracted from to the TP rate for respective business units, which can, in turn, increase or decrease both the transfer cost of loans and the transfer income on deposits. For example, negative market adjustments may be considered if there is sharp move in the benchmarks compared to the market deposit rates because of extraneous factors.

FTP Methodological Approaches

There are different approaches to implement FTP in a Bank:

Average Cost and Net Funding Approach are simple to implement in comparison with Matched Maturity Approach. These approaches do not need efficient IT infrastructure to implement FTP mechanism in Bank. However, these approaches do not consider marginal CoF based on market benchmarks, liquidity costs, maturity profile of the assets and liabilities, internal/external adjustments. Hence, these approaches fail to pass on the appropriate costs, benefits and risks to the liquidity generators and users. Further, the IRR and liquidity risks are not objectively managed under these approaches. Benchmark linked approach is bit superior compared to these approaches but still it does not consider other factors which are factored in in the Matched Maturity approach.

FTP Mechanism – Key Participants & Governance

The important stakeholders and their roles and responsibilities are briefly discussed below:

Benefits of FTP Mechanism

Some of the significant advantages of the effective FTP mechanism (viz. Matched Maturity approach) has been listed below:

Conclusion

FTP mechanism is an objective management accounting technique which is beneficial to Banks on multiple counts viz. appropriate pricing, effective risk management, correct performance monitoring, and prudent capital allocation decisions. Effective governing framework, availability risk related competencies, access to the relevant market information systems, effective internal IT infrastructure, detailed FTP procedures and comprehensive reporting mechanism will ensure smooth functioning of FTP mechanism in Banks.