Funds Transfer Pricing

Funds Transfer Pricing (FTP) is an internal measurement and allocation process that assigns a profit contribution value to funds gathered and lent or invested by the bank. It is a critical component of the profitability measurement process of financial institutions, as it allocates the major contributor to profitability, net interest margin. An intermediary is created within the organization (bank or insurance) to manage FTP, usually Treasury.

The business units of the financial institution routinely receive funds from their depositing customers and other third parties. These funds are then thereupon invested in loans and investments (sometimes through different business units) to borrowing customers and / or third parties.

The amount, terms, and interest rate of funds collected and invested are described in financial agreements between the organization and its customers. The interest payments on these funds contribute to the overall net interest margin of the institution, defined as the difference between interest revenue earned on funds used to acquire assets less the interest expense on funds gathered. In other words, funds transfer pricing determines the cost of funds for the asset side and a value of funds for the liability side. The net interest margin of the institution and the value of its financial contracts fluctuate as market conditions and the underlying cash flow of the funds change over time.

Even though, business units and the customers participate in the continuous intermediation process, the contribution to the net interest margin and value is not equal by all participants. The amount of funds received and provided is rarely matching. The task of the funds transfer pricing process is therefore to measure and assign the discrete contribution of funds – when assessing their overall profit contribution – by business unit, product and customer.

There are usually two methods to calculate the net margin and value contribution of funds, the pooled approach and a specific assignment approach. The pooled approach assigns funds to financial instrument pools created under a predefined set of criteria (e.g. type of balance, term, reprising term, payment frequency, and origination) with transfer rates derived either internally, based on actual rates earned or paid, or as an alternative, by market derived interest rates and adjusted for risk.

The specific assignment or single rate method approach uses transfer rates based on asset yields, which favors net funds provider’s contribution. The deficiency of that approach is it assumes that all funds have equal importance to the financial institution. No differentiations based on the value of fund attributes nor the market conditions at the origination of the transaction are taken into account. However, multiple pool approaches that use contemporary market rates lack the ability to benchmark management decisions made at the time of initial transaction pricing.

In any case, by assigning a transfer price to each component on the balance sheet, you can compare the earnings resulting from the use of each asset to alternative uses, compare the cost of each source of funds (liabilities) to alternative sources, and measure the profit contribution of each asset or liability. The typical reports are either two dimensional or OLAP reports that show initially the balance sheet and various columns with the comparisons and offer then drill down capabilities by the various criteria. Dashboard, showing the relevant measures like net interest margin and various visual representations of the balance sheet components, the comparisons mentioned above (e.g. in form of a bar chart), and the yield in form of a graph, are also commonly used.

Due to the fact that all financial instruments need to be pooled and calculated to receive the funds transfer prices the data volume is very high and the reporting tool need to be able to cope with this volume in an efficient way. In addition, the format of the two dimensional reports is usually stated. Hence, the BI tool needs to reflect this by providing “pixel-perfect” reporting, i.e. the ability to arrange all items on the report exactly as needed, something that not many reporting tools can master.