Transfer Pricing CAFRAL 2

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Funds Transfer Pricing in Banks

June 2014
In a bank, the common resource - funds or liquidity is shared by all the business units.
Therefore the most important function of Funds Transfer Pricing (FTP) is to provide a basis for
the exchange of funds between different business units of a bank. FTP is an internal allocation
and measurement mechanism for determining the pricing of incremental
loans/investments/deposits and for determining the profit contribution of various lending and
borrowing units of a bank. It is critical component of the profitability measurement process, as
it allocates the major component of profitability in a bank, Net Interest Margin (NIM). It’s a
management decision tool and is useful means to identify the areas of strength and
weaknesses within the bank.

Need to have a FTP framework

1. The assets and liabilities profile of the banks is becoming more complex with differing
maturities, fixed and floating rate interest and embedded options.
2. The interest rates are very volatile and changes in interest rates affect both the current
earnings as also the net worth of the bank.
3. In a bank there are simultaneously thousands of suppliers of funds and equally so
thousands of buyers of funds. There is no one-to-one match between the liabilities and
assets of a bank.
4. Banks are exposed to several major risks in the course of their business – credit risk,
interest rate risk, foreign exchange risk, liquidity risk, operations risk, etc. Net interest
margin (Interest income – interest expense)/ (Earning assets) of a bank is a function of
the interest rate sensitivity, volume and mix of its earning assets and liabilities. The
inherent interest rate risk and liquidity risk being assumed by the bank need to be taken
into account when evaluating the performance and profitability of a bank.
5. The phased deregulation of interest rates and the operational flexibility given to banks
in pricing most of the assets and liabilities requires every bank to have a basis to arrive
at risk based pricing for its products. It’s also important for the banks to be able to price
their products in a dynamic environment of changing interest rates and liquidity
situation.

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6. Interest, the largest component of bank’s profits, is received on loans & investments;
and paid on deposits. Without FTP it would seem that all deposits generate only costs,
whereas they’re the source of funding necessary for giving loans. As a consequence,
customers and business units that only raise deposit funds without giving loans would
be deemed unprofitable. It’s important for the bank to measure the contribution of
every unit, product and business to facilitate future strategy and performance
evaluation. FTP sets an internal price that allows estimating the cost of financing a bank
and assigning it to users of funds.

Imperatives of a robust Funds Transfer Pricing policy

 The FTP methodology deployed in a bank should be consistent and transparent.


 FTP should be applied at an individual transaction level and should apply to all assets
and liabilities including trading assets.
 FTP should be dynamic and available at the time of origination of the transaction, so
that it is used in decision making. This requires the need to have a robust system for
calculation and also dissemination across all business units. There must be a mechanism
for the branches and all business units to know on a periodic basis how they are faring,
on the basis of the defined FTP framework vis-à-vis the budgeted targets.
 FTP should be an integral part of the budgeting and planning exercise. It’s important to
ensure that the budgets and the performance evaluation are based not just on volume
target but also include profit targets at an aggregate as well as at business line, product
or branch level. In the absence of an integrated planning exercise, it’s possible that
individual units may achieve their respective volume targets, but the bank as a whole
may be worse off as there was no co-ordination between desired assets and liabilities
profile and their impact on risk and profits. E.g. asset group may achieve their target and
do significant home loan business at fixed rate, and on the other hand the liabilities
profile may continue to be predominantly short term FDs, savings and wholesale
borrowings of less than six months. This would result in a significant interest rate risk

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and liquidity risk for the bank, which may not be adequately priced-in in the absence of
a FTP framework and integrated planning exercise.
 There must be a clear linkage between the FTP outcomes and performance evaluation
of businesses.
 There must be a strong central funding unit which drives the FTP policy throughout the
bank. Its role would be to keep track of the overall priorities and objectives of the bank,
deriving the FTP rates curve, updating and dissemination, liquidity risk management,
maintain statutory reserves, satisfactorily respond to queries from all business groups,
deal with IT vendors, keep evaluating market development and review changes required
and put it to ALCO. It’s important to ensure that the central funding unit is staffed by
appropriately trained staff to carry out the above functions efficiently. The central
funding unit must be distinct from Treasury, which functions as a business unit. The
central funding unit should be seen to be neutral by all business units.
 For an FTP framework to be successful, the most critical thing is to have senior
management buy-in. It’s like a mirror and the management can make it as honest as
they want it to be, based on the commitment to look at true economics across business
lines. The senior management must play the crucial role of inculcating the culture across
the organization whereby FTP becomes an integral part of the decision making process.
 The sum total of the profits of all the business units and the central funding unit would
be the accounting profit of the bank. There should not be unusually high profit or loss at
the central funding unit. If the central funding unit is running a large deficit, then it
means the profit of individual business units/verticals would be unrealistically inflated.
The profit or loss of the central funding unit should only be as a result of the mis-match
risk that its carrying.

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Objectives of Funds Transfer Pricing

1. Aggregation of interest rate risk and liquidity risk in a central unit.

If a branch gives a fixed rate loan of 3 years and funds it with a 1 year deposit of the same
amount, the profitability of the branch over the next three years would be determined not just
by the credit risk assumed on the loan, but also based on the movement of the interest rates
over this period. Using the matched fund transfer pricing method, the three year asset of the
branch would be funded by the central funding unit by a three year notional liability and the
one year deposit of the branch would be matched with a notional one year asset at the relevant
transfer price for that maturity. This way the spread for the branch on its loan and its deposit
would be locked-in and not get impacted by the interest rate and liquidity risk. The central
funding unit would on an aggregate basis manage the entire interest rate risk and the liquidity
risk and the branch would be insulated from it.

2. Drive behavior of branches/business units to meet the overall objectives of the bank

Depending upon the existing profile of the assets and liabilities of the bank and the future
business strategy of the bank, the FTP should be so structured so as to align the individual goals
with the organization goals. For example, if a bank asset book is pre-dominantly mortgage loans
of long maturities, and now the business strategy is to enter and build a portfolio of auto loans
with three years maturity. Hence, the liability structure also needs to undergo a change and the
FTP should reflect the maturity preference of the bank so that there is sufficient incentive for
the branches to raise liabilities of the desired maturity. A skillfully designed transfer pricing
method will allow each entity/segment to focus on goals assigned by the top management

3. Highlight peculiar aspects of certain assets and liabilities and align the incentives of the
business units to them

A bank has an obligation to lend a certain percentage of its assets to priority sectors and there
is a cost to be borne by the bank if it fails to do so. This additional cost may be reflected in the

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FTP by either offering a lower rate for priority assets or offering a higher rate for non-priority
assets. This would then correctly align the goals of each unit with the overall goals of the bank.
Similarly, current accounts have no interest cost but have a significantly high transaction cost.
Bulk deposits on the other hand have high interest cost but low transaction cost. In order to
ensure that the liability cost are comparable, transaction cost component may also be factored
in while arriving at the FTP for current and savings account.

4. Provide guidance for risk based pricing of products at a transaction level

The pricing of the product should reflect the cost of funding (in case of assets), the operations
cost, cost of credit risk (in case of assets), cost of embedded options (e.g. prepayment option),
cost of managing liquidity, cost of maintaining statutory reserves and interest rate risk. A robust
transfer pricing framework provides a consistent basis to arrive at this price at a transaction
level. The price so arrived at serves as guidance to the business units, which they may suitably
and consciously modify, if required, to take care of competition and customer relationship. In
the absence of a well-implemented FTP policy, product pricing may be devoid of the true cost
to the bank and would solely get determined by external factors and hurt the bank in the long
run. While competitive factors are indeed very important and the bank may not always be able
to set the price for the customer, the FTP methodology would at least highlight which products
make more money for the bank and which make less money for the bank, so that it may decide
where the volume focus should be.

5. Provide objective criteria for business unit/product performance evaluation

Volume based evaluation of business performance is faulty simply because there is no direct
correlation between volume of business done and profit earned. It is possible for a bank to
increase its net profits even while there is shrinkage of its balance sheet size. If the balance
sheet of the bank has increased but the profit has not, it could be because of multiple factors
such as that incremental business was being done at a negative margin or there may be higher
than expected credit losses from existing assets or operational costs may have increased. There
are multiple drivers of the bank’s profitability and the extent of risk assumed by a bank impacts

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the current and future profits of a bank. FTP framework provides a basis for risk attribution and
return evaluation. FTP can be used as an effective tool to focus the businesses on organization
goals of consistent growth of profits.

Methodology for Funds Transfer Pricing

There are different approaches for FTP which is prevalent like:


 Pooled/average cost method – Based on average cost of all outstanding liabilities a
single transfer price rate is arrived at and used for all assets and liabilities.
 Net transfer of funds method – Based on net transfer of funds (difference between
assets and liabilities) between business units and funding unit.
 Market benchmark linked method – Based on prevailing market benchmark rates for
different maturities such as MIBOR, T-bill rate, G-sec rate, transfer pricing curve is
determined.
 Matched Matuirty Marginal method – Based on incremental cost of raising funds for
different maturities. Under this approach rates charged for the use of funds and rates
credited for providing funds are based on matching the maturity of the asset and
liability instruments to the FTP rate that corresponds to that maturity and thus there is
segregation of the interest rate risk and liquidity risk from the business unit profitability.

The average cost method is easy to implement but does not take into account the current costs
and the term structure of interest rates. The net transfer of funds method (Amount of total
assets and liabilities are netted out, without considering the respective maturities) minimizes
the complexity in the use of transfer pricing, but under this the cost of interest rate and
liquidity risk would continue to impact the profits of the branch. Another reason why using the
net transfer of funds method is not appropriate is that the potential for assets and liabilities
may not be uniform for all business units and therefore the practice to net off would not be fair
and consistent for all the business units/branches. The market benchmark linked method
provides an objective basis to set the rates but would work if the markets are liquid and

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competitive. In the absence of borrowings of banks being linked to the same benchmarks, the
movement in the market rates and cost of borrowings of the bank may not be synchronized.

Though each of the methods has their own advantages and disadvantages, matched maturity
marginal method has some distinct advantages over other methods. First, it recognises that the
costs and inherent liquidity risks are related to the maturities of assets and liabilities, and
therefore allows different rates to be assigned to products with different maturities. Second, it
recognizes the importance of having changes in market conditions quickly and efficiently
incorporated into the rate used to charge and credit users and providers of funds, and
therefore relies on the marginal cost of funds. Third, it incentivizes the bank to eliminate
costliest marginal funds so that threshold for lending rate reduces. Fourth, it establishes
threshold for each decision to be profitable on an incremental basis.

The central funding unit would determine the transfer price curve for various maturities from
time to time based on the policy approved by the ALCO. The bid curve (i.e. the transfer pricing
curve used for liabilities of the bank) would be based on the marginal market rate at which the
bank can borrow for different maturities plus a funding spread to cover servicing costs. Offer
curve (i.e. the transfer pricing curve used for assets of the bank) is calculated as bid rate
adjusted for the following:
 CRR and SLR negative carry – Benefit of CRR may be given for inter-bank
liabilities.
 Liquidity charge for maintenance of liquid assets - The extent of liquidity
cushion to be maintained by the bank may be determined through the use of
statistical behavioural model, stress-testing and scenario analyses. The cost
of maintaining such liquidity buffer would be added to arrive at the offer
rate. Also, business activities creating the need for the bank to carry
additional liquidity such as undrawn facility may be charged based on their
expected usage of contingent liquidity.
 Term premia depending upon slope of deposit rate curve and other market
rates.
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Every liability raised by the business unit would be “transfer priced” using the prevailing bid
rate for the matching maturity. While arriving at this, liabilities such as current account/savings
account with non-determinate maturity may be categorized based on statistical behaviour
model. Similarly, every asset at the time of origination would be “transfer priced” using the
prevailing offer rate for the relevant maturity. For amortising assets, each cashflow may be
treated as an individual bullet loan for that maturity and priced accordingly to arrive at a
composite rate for that asset. The difference between the rate charged to the customer and
the transfer price on that asset would be the net interest margin on that transaction
attributable to the business unit.

The final rate to the customer may thus be broken down into its various components under the
FTP framework as follows:

Transfer Pricing

3 year asset Rate to Client


creation rate
x
Credit spread
Offer Curve
3 year offer rate
Bid curve
Cost of Funds
Mismatch Spread

CRR / SLR carry

1 year bid rate


1 Year liability spread or
Funding spread
1 year Liability
creation rate x

1 year 3 year

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Systems support for implementing FTP framework

The FTP system should be robust and parameterized so that based on the specific inputs
provided by the bank of its FTP policy, it should be able to compute the transfer pricing curves
in a seamless and dynamic manner.

There must be an online pricing calculator available to all the business units to ex-ante estimate
the contribution of that product based on the prevailing transfer price, so that it would provide
them guidance on pricing.

There must be periodic dissemination of MIS to business units of the contribution of the
business generated by them based on the FTP policy.

Conclusion

It’s important for every bank to have a robust and well laid out Funds Transfer Pricing
framework which is conducive to the complexity and the nature of business of that bank.

For any comments/feedback/queries on this please write to Smita Aggarwal at


[email protected]

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