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Funds transfer pricing and A/L

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by Payant, W Randall | 2000 | 0 Comments

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Funds transfer pricing (FTP) is an internal measurement framework

designed to assess the financial impact of a bank's sources and uses of
funds. FTP allocates net interest margin variances caused by the
imbalance of funds provided and used by business units within the
bank. Results of the FTP measurements can be used to evaluate the
profitability of products and customer relationships, and to isolate
returns for various risks assumed in the financial intermediation
process. While there are numerous transfer pricing frameworks and
techniques, matched funds pricing methods are generally viewed as the
most conceptually pure.

Matched FTP's purity stems from its

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assignment of a market-based
"matched repricing term" transfer CBS MoneyWatch.com
rate to each balance sheet Blogs
transaction origination. Transfer
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and should represent the alternative
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"opportunity" rate for the bank's Job Growth
sources or uses of funds. Many FTP
practitioners recommend the use of Why the Housing Market is
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a single curve, so asset and liability
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transactions of identical attributes
are assigned identical transfer rates. What's Good for Wal-Mart
When measuring performance, a Isn't Necessarily What's
transaction's transfer rate (or Good for America
spread to a repricing index rate if Mega Millions: How to Win
the instrument's rate is adjustable) a Jackpot
remains unchanged over its
repricing life. Effectively, this
insulates the transaction's margin contribution from the effects of
subsequent market interest rate changes. Profit margins of transactions
are known at origination.

Matched funds transfer pricing has been linked to A/L management as

a way to centralize the bank's overall funding mismatch in a business
unit specifically assigned the responsibility of monitoring and managing
interest rate and liquidity risks. The bank's funding mismatch exposure
is caused by the varying characteristics of the sources and uses of
funds. While this is one of matched funds pricing's mantras, its usage
to actually manage the funding position is somewhat dubious. This
article discusses various ways matched funds transfer pricing can be
used in AIL modeling and funding risk management.

First, it must be understood that matched fund transfer pricing does

not mean transactions are actually match funded or paired off against
one another. Banks generally do not have the capability or desire to
eliminate all funding mismatches. Indeed, the boards of some banks
believe mismatches should be encouraged to potentially improve
profitability.

The assignment of market-derived transfer rates prescribed by

repayment attributes allows lenders and deposit gatherers to

http://findarticles.com/p/articles/mi_qa3682/is_200001/ai_n8879582/[05/04/2011 09:23:12]
Funds transfer pricing and A/L modeling - Journal of Bank Cost & Management Accounting, The Articles | Find Articles at CBS MoneyWatch.com

determine coupon rates (or yields) sufficient to compensate the bank

for the various financial risks assumed. Lending staffs know the
inherent cost-of-- carry of a loan for its estimated term, thereby
freeing them to price only the spread necessary to compensate for
perceived credit risk and operating expenses. Deposit gatherers know
the value of the funds to the bank and can therefore set deposit rates
accordingly. Effectiveness of origination pricing decisions can be
assessed. This is where many discussions of matched FTP benefits end.

While providing a transfer rate at origination helps improve pricing

decisions, transfer rates can also be used as input to the bank's
performance forecasting models. Using transfer rates allows for the
forecasting of business units' margin performance. Additionally, the
residual spread between the coupon and transfer rates can be used in
simulating funding center strategies and measuring mismatch risk
exposures. These two distinct uses of matched FTP require two
different analyses and uses of transfer rates in financial modeling. To
understand these distinctions, the difference in origination-term and
remaining-term transfer rates must be distinguished and understood.

TRANSFER PRICING FOR PERFORMANCE FORECASTING

Often managers want to forecast their business unit's net interest

contribution. The simplest forecast of contribution generally occurs in
the budgeting process. Here, forecasts of portfolio balances are
multiplied by an associated yield, cost of funds, or spread over an
index rate to determine net interest contributions. Future balance
sheet volumes are usually projected without consideration of their two
distinct underlying components; business already on the books and
business yet to be booked.

Business volume already booked provides the foundation for projecting

future net interest contributions. A large portion of a bank's near-term
interest income and expense is already pre-ordained for the volume of
existing business that will be on the books during the forthcoming
planning horizon. Over time, existing transactions run off the books,
and are replaced with newly originated business.

To allocate this pre-ordained net interest contribution to each business

unit requires assigning value to their transactions' margin contribution.
This value is the spread between coupon and transfer rates of their
transactions assigned at time of rate resolution. The margin
contribution of the origination unit is the difference between its
transactions' contribution spreads multiplied by their associated
principal balances. Net margin is credited to the business unit
throughout the remaining lives of its existing transactions.

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