Transfer price mechanisms are used in businesses with multiple branches. These businesses are large and sprawling, so TPMs act to rein them in through unified policy. Head offices of banks use TPMs to determine fund allocation through lending or advancement to a particular bank branch. Although more complex and accurate than past systems of determining profitability, TPMs have their disadvantages.
The Role of TPMs
The transfer price mechanism measures the performance of institutions, including banks, more accurately than older methods such as just looking at profitability. Profitability alone isn't the best indicator of success for bank branches because it's linked to their commercial independence. This can't be entirely achieved when branches are managed by head offices. All bank branches answer to a head office that lends and advances funds at a fixed rate. Because each branch of a bank has a different flow of business, some are stronger than others. Likewise, each branch usually excels in a specific area, such as lending scope or deposit potential. Measuring strengths and weakness allows head offices to determine fund allocation for the branches they oversee.
One objective of TPMs is the evaluation of true profit and operational efficiency of bank branches. When this objective is performed correctly, the correct amount of funds and advances are provided to branches that will most effectively use them. This also ensures equitable distribution of profit. These components work together to accomplish the overall objective of keeping the funding stream from head office to bank branch as stable as possible.
The unitary system is the simplest because there's only one rate for lending and borrowing from the head office. It doesn't matter whether bank balances are based on credit or debit. The dual system uses one rate for borrowing and another for lending by the head office. Multiple systems implement multiple price mechanisms. Deposits and advances are provided by the head office at different rates -- although branch profitability is based on both, instead of stressing one or the other.
Disadvantages of TPMs
The unitary system has two flaws. Bank branches supported by advances reflect higher profits than those supported by deposits. This happens because deposits garner more interest payments than advances. Additionally, the unitary system fails to identify the performance between fund allocation and its performance. The dual system doesn't take into consideration interest rate structures determined, not by the head office but the market itself. Rural branches are put at a disadvantage because their indications of profitability -- based on savings and term deposits -- is inaccurate. Advance-based branches are inaccurately represented, too, because there is no differentiation between types of advances bundled together. Term deposit-based branches indicate lower profits because the interest rate is high. Multiple systems are prone to problems related to international banking practices. Although the cost of running each branch differs from branch to branch and changes year to year, this is not reflected in profitability reports until the cost is stabilized. Overall, there are no set rules regarding profitability, so there is vulnerability to any change in business operations.