Funds transfer pricing

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Funds transfer pricing (FTP) is a process used in banking to adjust the reported performance of different business units of a bank. A bank could have different kinds of business units. FTP can be understood as a mechanism for distributing revenue between profit centres, which can contribute to a better financial performance evaluation of these business units. The split of these units between deposit-raising units and funds-advancing units affects whether they receive a positive or negative revenue adjustment. Both borrowing and lending contribute to the performance of the bank as a whole. FTP is a mechanism to adjust these profitabilities to incorporate true funding costs. Therefore, FTP can be seen as an internal measurement tool to demonstrate the financial impact of destination and source of funds.

The two major objectives of FTP in financial institutions are motivating profitable actions and comparable financial performance evaluation among business units, and when properly utilized, transfer pricing systems allow comparable financial performance evaluation of net fund generators and net fund users. Without an FTP system, net fund users receive credit for interest income without being charged for the total amount of interest expense associated, while net fund generators are charged by interest expense without being credited with revenue of interest associated. In such an environment, net fund users have an advantage because all interest revenues are linked to financial assets and all financial expenses are linked to financial liabilities, and this causes a distortion in business units' financial performance as net fund users present themselves as more profitable than net fund providers.

FTP may improve profitability through improved pricing, enhance asset and liability management, and provide an important component of an integrated profitability reporting solution. However, management choosing to adopt FTP must be aware of two potential problems. First, management has to determine a fund transfer pricing interest rate which aligns with organization's strategy. Business units which are net fund generators benefit from higher fund transfer price interest rates whilst net fund users benefit from lower fund transfer price interest rates. Second, management has to enforce transfer pricing policy as some business units may lack incentives to adopt such policy. Although fund transfer price does not distort the analysis of the overall financial performance of the organization, using fund transfer pricing some business units may be making a loss even though the organization is profitable.

As a practical example of implementing a FTP system, an intermediary is created within the organisation usually treasury or central office. All the fund-raising units raise funds from the market at a particular rate and lend the same to the central office at a higher rate. All the lending units borrow the funds from the central office at a particular rate and lend the same to the borrowers at a higher rate. The central office rate is notional in nature and is aligned to market conditions. Thus for all the units there are two rates available to measure the performance. For a deposit-raising unit the difference between interest paid to the deposit-holders and interest receivable from central office is the contribution to the bank's profitability. For a lending division the difference between Interest payable to central office and the interest received from the borrowers is the contribution to the bank's performance.

Funds transfer pricing is a way to value the margin contribution from each individual loan and deposit that a bank has on their books. The way each instrument is valued is by calculating a funds transfer charge on the asset side (loans) and a funds transfer credit to the liability side (deposits). The funds transfer charges and credits are calculated based on the banks opportunity cost of borrowing at the time of origination. The value assigned to a deposit account would be equal to the difference between the cost of an equivalent term borrowing less the cost that is actually being paid on the instrument. For example, if a bank can obtain 3-year borrowing at 3% but is only paying 2% on their 3-year CDs each CD is providing 1% of value each of the 3 years the CD is open. The net interest margin assigned to the CD would be 1% * the balances each of the 3 years. The same calculation is made on the loan side. For example, if a bank is making a 3-year fixed loan at 4% and they can obtain 3-year borrowing from an outside source at 3% then the loan would be providing 1% (* balance) each of the 3 years the loan is open.

FTP is therefore a revenue adjustment made to the bank's Balance Sheet to reflect the cost of funding.

For example, a business unit which manages funds for high-net-worth individuals will create cash which is held on deposit. That deposit will accrue interest and therefore the Wealth business unit's profits will have to be increased by the deposit interest which can easily be calculated by using the prevailing rate of interest.

This approach became problematic during the 2007/8 financial crisis because actual interest rates paid began to differ from published rates such as Libor or bank base rates vary. With poor credit availability, the profit adjustment made in favour of depositing business units was effectively understated. This had been less an issue when banks' borrowing costs were close to base rates or quoted rates such as LIBOR.

Failure to calculate FTP correctly can cause loans to be much less profitable than they initially appear and the fact that banks have extended unprofitable loans is a key factor in the recent financial crisis.

FTP has become important because banks are expected to state their funding costs accurately as a regulatory requirement, because funding costs affect a bank's liquidity reporting. Failure and bail-outs of banks has made reported liquidity a hot topic. FTP calculation is complicated by a number of factors which make calculation of the revenue adjustment necessarily difficult. Factors affecting funding cost include the length of time an asset or liability is repaid (Liquidity Term Premium), the extent to which an asset has been or can be securitised (which affects its liquidity) and the *behaviour* of customers in particular product/customer niches such as customers' propensity to withdraw long-term deposits at a penalty or to repay obligations such as mortgages early, all which affect real funding cost. This behaviour factor complicates the calculation of FTP and has required significant and expensive changes to banking systems. Balance sheets now incorporate new attributes for customer and product which were not previously significant reporting dimensions.

One important issue to be considered in calculating FTP is the need to value funding costs on an "at arms length" basis.

To understand "at arms length" one has to understand how relationships affect behaviour. Some conventional transfer pricing issues can be considered to explore this.

A good example is a father selling a home to his son. The value of such a transfer may not be considered to be the same as what would be achieved on the open market.Similarly businesses often manipulate sales of asset through inter-company trades to maximise profitability in low tax environments.

In banking terms the fact that a loan is made between business units may reflect agreed or contracted recognition of (too low in the financial crisis) costs rather than prevailing actual accurate funding costs and this is both an important audit concern and of taxation interest as transfer pricing affects where and in which business unit profit is reported.

As a result of the attention on funds transfer pricing that resulted from the 2007/2008 financial crises, the U.S. Federal Reserve, Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency issued regulatory guidance for large banks formalizing an approach to funds transfer pricing for the first time. The guidance required a number of formalized processes including requiring large banks to prepare funds transfer pricing reports and a standardized funds transfer pricing process be implemented across the institution.

Funds transfer pricing

Wednesday, October 10, 2018