Funds Transfer Pricing: A Management Accounting Approach within the Banking Industry

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INTRODUCTION

Funds Transfer Pricing is a management accounting tool used within the banking industry that can be used to improve profitability. Through Funds Transfer Pricing (FTP), a bank can better analyze its net interest margin1, which typically serves as the traditional banks' largest source of profitability2 (Kimball, 97). Funds transfer pricing provides management with a means of crediting both funds-using and funds-generating business lines with the entire net interest margin. The FTP rates used within a given bank reflects' their cost of funding as an institution.

When utilizing FTP within a bank, FTP rates are assigned to all earning assets to reflect the true cost of funding. FTP credits are applied to all interest-bearing liabilities to reflect the benefit to the bank for the collection of funds. For both earning assets and interest-bearing liabilities, a profitability spread is calculated in order to analyze the contribution the balance sheet item has made to the net interest margin. For earning assets, the profitability spread is calculated as the yield (from interest income) less the FTP charge. For interest-bearing liabilities, the profitability spread is calculated as the FTP credit (for the collection of funds) less the yield (from interest expense). The FTP rates applied to each account reflect the rates for wholesale investment/borrowing alternatives for the institution. Within this study, we will provide an overview of FTP fundamentals and describe how financial institutions can use these techniques to improve their profitability.

Overview of Funds Transfer Pricing

With FTP, each customer account is assigned a rate that is based upon the structure of the product. For example, the following items all impact the calculation of the FTP rate: term structure, repricing characteristics (fixed or floating rate), payment structure, and interest rates at the time of the origination or rate change date. For loans, the longer the term of the account and the less frequent that the rate paid from the customer changes, the higher the cost of funds incurred by the bank under a normal yield curve. For example, a fifteen year fixed rate mortgage at origination has a higher cost of funds to a bank than a floating rate home equity loan with a five-year maturity. In order to fund these loans, the bank would have to borrow the money to fund each loan for fifteen years and five years, respectively. Because the cost of borrowing these funds is greater for the fifteen-year loan, the FTP rate charges reflect this cost to the bank.

For deposits, the longer the term of the account, the greater the FTP credit applied to the account under a normal yield curve. For example, a five-year certificate of deposit provides longer term funding for the bank to use to fund loans and has greater value than does a one-year certificate of deposit. In the case of the five-year certificate of deposit, the account would receive an FTP credit equivalent to the five-year rate on the banks' funding curve. This FTP rate would reflect the cost of the bank borrowing the funds for five years on the wholesale market3 at the time the deposit was originated. It is important for banks' to encourage their employees to collect deposits, because when priced effectively, they are a much cheaper source of funding loans.

In order to provide value, banks' must create a well defined and sophisticated funds transfer pricing system. "A funds transfer pricing process that assigns a market-based contribution value to each source and use of funds, based on the underlying account or transaction attributes at the time of origin, is the most comprehensive method for inclusion in an overall profitability measurement process (AMI/v Research Committee,2001)." Software programs can be purchased to aid in the assignment of funds transfer pricing. The most sophisticated method of assigning FTP rates is matched-term funding in which unique FTP rates are assigned to each source and use of funds at the time of origination and each subsequent scheduled rate change. …