Banker's Guide to Funds Transfer Pricing
Funds transfer pricing is a method used by banks to measure how each source of funding (deposits and loans) contributes to the bank’s profitability. A bank’s business depends on the deposits it receives. It uses these funds to make loans or investments. Interest payments made on these funds determine the bank’s overall net interest margin. The net interest margin typically is the largest source of bank profits. Because funds transfer pricing helps to calculate the net interest margin on a bank’s funds, it is one of the most important tools for measuring the profitability of each of a bank's funding sources.
Choose a funds transfer pricing method. The most popular methods are single pool rate matching, multiple pool rate matching, and matched maturity.
The single pool rate method uses only one fund transfer rate (funding cost for loans and value of deposits) to credit all funding provided and to debit all the funding that is used. This simple method does not take into consideration factors such as maturity and embedded risks.
Multiple pool matching splits the balance sheet into pools of assets, which are then matched to the opposite side of the balance sheet to establish an appropriate funds transfer rate.
Matched maturity matches each customer account to a market-driven index. This method is popular and accurate, because the transfer prices assign a market-based contribution value to each source and each use of funds.
Establish a funding curve that best reflects the use of funds on the wholesale market. Some of the best choices include an interbank rate such as the London Interbank Offered Rate, or LIBOR; interbank swap curve; or a Treasury yield curve. Cash flow, repricing and maturity of the financial instrument is used to determine the point on the transfer curve to find the transfer rate. The funds transfer rate chosen should match the market rate on the transfer curve as close as possible. The funding curve, “simply plots the relationship between time to maturity and yield to maturity for a give type of financial instrument” (Reference 1).
Review variables associated with each loan or deposit once the transfer rate has been chosen. This will help determine whether the transfer rate is adequate. For loans, review fixed and variable lifetime costs associated with the loan and the cost of assigned capital based on all embedded related risks (credit, interest rate, market, liquidity and operational).
For deposits, determine the fixed and variable lifetime cost associated with the deposit and the cost of assigned capital based upon embedded risks (interest rate, market liquidity, and operational).
Find the credit spread for loans and the deposit franchise spread for deposits. The credit spread, earned by the bank for assuming credit risk, should be adequate enough to compensate for credit losses and to provide adequate profitability. For example, on a one-year loan with a rate charged to the customer of 7 percent and a transfer rate of 5 percent, it's 2 percent.
The bank earns the deposit franchise spread for funding loans and investments. It must be adequate to compensate for operating costs of the branch, retail delivery systems and general overhead, and it must produce an adequate profit for the bank. For example, a three-month certificate of deposit at 3 percent, matched to a transfer rate of 4 percent, means 1 percent.
Compute the net interest rate margin, or IRM, for all the funds used by the bank. Subtract the total interest rate on funds deposited from the interest earned on the funds used for loans and investments. This shows the bank’s profit or loss.
There is no one right answer on the best practice in choosing a bank’s fund transfer pricing curve. The bank must choose the best curve in relation to it's own needs and goals.
Using credit risk-free marketing indexes, such as a Treasury yield curve, encourages banks to make loans that are less profitable than they appear to be. It also tends to discourage deposits that could be profitable.