Funds transfer pricing – What is it and why it is important for banks
Funds Transfer Pricing is a common method in banking. Though, it can be quite a complex thing. Therefore, we have written this article where FTP is covered from A to Z.
What is Funds Transfer Pricing (FTP) in the first place?
The basic objective of Funds Transfer Pricing (FTP) is to establish an internal reference that allows for a meaningful profitability comparison (contribution to net interest income) across different transactions, products, and business lines by attributing relevant costs (benefits) for users (providers) of funds and liquidity. Simply put, an FTP framework will try to establish the all-in cost/value of funds for the firm, taking into consideration the cash flow and risk profile of these funds.
Resulting metrics allow financial institutions to gain valuable insight into the composition and evolution of their net interest income and product/customer level profitability:
- FTP removes interest rate and liquidity risk from product and business line results and centralize them in a Treasury mismatch unit for management.
- Business lines performance measurements are better aligned with their responsibilities (manage commercial spread and volumes)
- Help the organization to move away from traditional volume driven targets/incentives.
Why Funds Transfer Pricing matters in banking?
Without Funds Transfer Pricing calculating and comparing the profitability contribution of individual transactions, products, business lines, etc. is impossible and can lead to poor decisions in terms of resource allocation and balance sheet sustainability.
Some of the most basic questions that an FTP framework needs to answer are:
- Assess the relative contribution of asset generating vs. liability generating units. Without even a basic FTP, asset generating units tend to be favored as they are perceived to generate “revenue”, while liability generating units are looked down at as they are viewed as a “cost center”. This view is clearly wrong as it fails to attribute a “raw material cost (money)” to those assets and some benefit to the liabilities.
- Assess transaction and product/business unit profitability based on their own merits. How would you compare the profitability of two otherwise similar transactions (exposure, credit risk, reference rate, etc.) that have a different maturity date? In normal conditions (a positive sloped yield curve) longer dated transactions will attract a higher yield (e.g., a one-year loan at 2.0% vs. a 10-year loan at 4.0%). If you can only fund one of those loans, which one should you accept? Here FTP will help to recognize and price in related market risks and help you select the most profitable transaction.
- Provide insight into the net interest income sustainability. How is your current net interest income affected by previous good/bad asset-liability management decisions? Is it sustainable?
FTP and profitability management
A properly implemented FTP framework, will drive value creation by informing the strategic decision-making process (resource management), enable risk-based pricing, link incentives to value creation and strategic initiatives, and provide and effective balance sheet steering mechanism.
- The ability to properly account for direct and indirect costs (e.g., liquidity buffers) is key to driving profitability and providing the right incentives across the organization that are aligned with value creation. Failure to do so can result in unintended cross-subsidies, rewarding units for undue risk taking and risk concentration (i.e., excessive demand for underpriced resources).
- With net interest income (NII) usually representing 70+% of total revenue, FTP spreads are an important and necessary component of any risk adjusted performance metric (e.g., ROE, EVA, RAROC) and financial resource management framework. Simply put, a flawed FTP implementation will lead to questionable profitability and performance metrics.
Standard FTP methodologies (for Net Interest Margin)
Across the industry the matched maturity Funds Transfer Pricing methodology is now recognized as a best practice. Individual transactions are priced at deal inception at the relevant FTP rates based on their cashflow and repricing characteristics:
- For products with contractual maturity, FTP rates are calculated and applied at the transaction level based on their contractual maturity (fixed rate products) or interest rate (repricing), and liquidity (amortization) characteristics.
- For products with no contractual maturity (e.g., demand deposits, credit cards), FTP rates are usually applied at the product level, considering their behavioral interest rate and liquidity risk characteristics. Where relevant, portfolios will be broken down by segments if there is evidence of different customer behavior across segments.
- Legacy single-/multi- pool-based approaches have been shown to be deficient and have been mostly phased-out.
The three separate components of FTP
While every bank seems to have a slightly different approach, with different levels of sophistication/complexity, the common building blocks are:
– Direct funding cost, usually broken down into two components:
- Interest Rate Risk: Derived from observable market rates (e.g., Libor and Swap curves) at which Treasury might hedge this risk. In some cases, different curves are applied for specific assets (e.g. covered bonds) to reflect asset specific characteristics.
- Direct Liquidity Cost: Which represents the bank’s own spread over the reference rate (e.g., Libor swap curve), which for very large banks is observable from their wholesale traded debt. For smaller banks, or less developed markets, proxies will have to be derived.
- Cash flows (magnitude and timing) are usually adjusted for expected prepayment rates (resulting in shorter expected life).
– Indirect liquidity cost (Contingent liquidity, or buffers): Reflecting the cost of holding liquid assets to cover potential unforeseen liquidity requirements. These can be driven by regulatory (e.g., LCR) or internal (e.g., Stress Test results) requirements.
– Optionality: To reflect the cost of any optionality provided to customer such as rate caps/floors, prepayment (uncompensated), etc.
Reshape your margins with FTP
While the technical aspects can be endlessly debated and improved, at its core a good FTP implementation will provide the right incentives in terms of:
- Recognizing value generating transactions, products, etc.
- Enable and incentivize better front-line decision making and risk-based pricing.
- Influence volume and terms of new businesses and portfolio composition, supporting balance sheet sustainability and align business incentives with risk management and strategic objectives.
Extract more value from FTP by following these steps
The biggest benefit, and sometimes surprise, from implementing an FTP framework comes from obtaining a much clearer picture of the relative contribution to net interest income from the different products and business lines. Large ticket business lines tend to look less favorable under the FTP microscope, while contribution from deposits might be a positive surprise (depending on the market rates level).
- Transaction, product, channel, and business unit level financial performance can be managed both on the front- (new deals) and back- book (retention) in terms of actual NII contribution (vs. a traditional volume driven approach)
- Having granular information (transaction level) and the capacity to model the current balance and spread runoff, provides a much better starting point for performance evaluation and profit planning.
- When properly setup, FTP will also help to understand Treasury’s contribution and performance in terms of its Asset-Liability Management, removing what is frequently a “black box”.
For FTP to make a difference a crucial change needs to happen: Linking FTP results to the way business lines targets are set and performance is measured and rewarded. This will often generate significant pushback from the different business units (sometimes with, other times without merit). Having a well-established, granular, transparent, comprehensive, coherent and auditable FTP framework becomes key in terms of obtaining organizational buy-in and towards a more efficient balance sheet management practice.
Watch Webinar Recording: Extracting value from your ALM infrastructure: Leveraging your ALM & FTP to drive profitability