As part of the overall management information and control system, a funds transfer pricing system handles the problem of charging net funds users and crediting net funds providers at the profit center, product, and customer levels. Properly utilized, a transfer pricing system motivates profitable pricing actions, allows comparable performance evaluation of funds users and providers, and supports asset/liability management, among its other uses and objectives.
There are three methods available to perform transfer pricing with variations thereon that provide the flexibility for use by all sizes of banks. The single pool method is the simplest and the least effective of the three. The multiple pool method is better in that it is more reflective of market reality and more likely to result in profitable actions being taken. The most effective and the most complex method is called Matched Maturity Marginal Funds Transfer Pricing or MMMFTP.
Many banks may be utilizing some form of transfer pricing. However, unless the system motivates profitable actions and provides for comparable performance evaluation - two major objectives of transfer pricing - there may be little to no benefit realized in terms of earnings enhancement. For small- to mid-size banks, a simple version of the multiple pool method should prove fairly effective. Instead of using only one rate, net funds providers would be credited with a rate related to the bank's overall average yield on earning assets and net funds users would be charged with a rate related to the overall average cost of funds. This would allow greater independent control of loan and deposit generation, as well as provide for more objective performance evaluation.
A funds transfer pricing system is a major tool available to assist in enhancing profits, as profitability, rather than growth, has become the key to bank success and survival. No longer can banks assume growth will automatically result in profits, as may have been the case in the past. Banks are apparently well aware of this, as evidenced by a BAI (Bank Administration Institute) research project that found the majority of respondents indicating use of some form of funds transfer pricing. Profitability reporting was cited by about half the respondents as the primary use of the transfer pricing system.
On an overall basis, the bank is either in an excess funds position and is able to invest in securities/federal funds sold, or is in a deficit position and needs to purchase funds. However, on a profit center level there are generally net funds users and net funds providers. Branches are usually providers as their deposit balances usually exceed their loan balances. Administrative departments such as charge card, dealer center, international banking, etc., generally would have loan balances in excess of any deposit balances. These areas would be users of funds. Although reference will be made to profit centers, the concept of net funds users and providers is equally applicable to products and customers.
Without a transfer pricing system, net funds users would receive credit for interest income without being charged for the full amount of associated interest expense, while net funds providers would be charged with interest expense without being credited for the full amount of associated interest income. In such an environment, net funds users have the advantage because all interest income is associated with assets and all interest expense is associated with liabilities. This makes the net users appear more profitable than the net providers. There is no problem for the bank as a whole, as all interest income and expense are taken into account.
However, bank management should know how and where profits are being generated within the bank on an organizational, product, and customer level. This is where a funds transfer pricing system would be utilized. …