Today's financial services industry is a highly competitive world. Banks are faced with competition from not only other financial institutions, but also, thrifts, insurance companies, investment companies, mortgage companies and others. Banks are facing immense challenges to achieve sustainable profitability. Historically low interest rates are compressing margins and forcing banks to enhance their performance management capabilities (Convery 2003).
One of the biggest measures of a bank's profitability is its net interest income. Net interest income is by far the largest driver of product profitability, typically accounting for up to 80 percent of a bank's revenue (Coffey, 2001).
Funds Transfer Pricing is an analysis tool that can be used to help a bank measure its profitability in a variety of different ways. It allows management to compare the profitability of different product lines within the company, and it can be drilled down even further to allow comparison between individual employees. It is also very useful for comparison between branches. This study will discuss the fundamentals of Fund Transfer Pricing (FTP) and talk about how Funds Transfer Pricing will affect the profitability of two branches of a bank.
Fund Transfer Pricing:
In simple terms, transfer pricing is"A transfer price measures the value of products furnished by a profit center to other responsibility centers within a company. Internal exchanges that are measured by transfer prices result in (1) revenue for the responsibility center furnishing (i.e. selling) the product and (2) costs for the responsibility center receiving (i.e., buying) the product." (Anthony, 2004). In the banking industry, this would be deposits that are collected by one branch and used by another to fund loans. This process is usually handled using an FTP system.
When a bank makes a loan to a customer, the funding for this loan has to come from one source or another. Typically, the funding in a financial institution will come from deposits collected by the bank. This type of funding is normally the cheapest and most desirable; however, when deposits are not sufficient to fund all the needs for cash that the bank has, the bank will have to get additional funding in the wholesale market. Therefore, each deposit brought in to the bank has a value to the financial institution for funding purposes, and, by the same token, a loan also has an underlying cost of funds and is not just interest income for the bank, as it would look in a typical income statement analysis. The purpose of FTP is to place a value on each deposit and assign a cost to each loan that a bank has.
When implementing an FTP system, banks' must determine a "funding curve" that most reflects their source or use of funds on the wholesale market (Rice 2004). Many banks in the past used United States Treasuries as their funding curve. But recently, the government has dropped some buckets from its information. Therefore, many banks have switched to the LIBOR/Swap curve. The funding curve for a financial instrument shows the relationship between time to maturity and interest rate. Many banks make adjustments to these curves to customize the curve to fit the banks unique lending environment. The liquidity premium shown in Exhibit 1 is such an adjustment. This premium is added to the swap curve rate to calculate the total FTP rate, which in this case would be 4.22 percent.
Next, each loan or deposit that the bank has is assigned a rate based upon this adjusted funding curve. The rate that is assigned to these customer relationships will vary based upon the characteristics of the relationship. One characteristic that will cause a rate to change is time to maturity. For instance, a 5 year fixed rate note will be assigned a different rate than a 5year variable rate note. Also, for loans, the longer the term is to maturity, the higher the rate to fund …