Journal of Performance Management

Transcription

1 Journal of Performance Management Best Practices & Strategic Value of Funds Transfer Pricing - ORLANDO B. HANSELMAN - Funds Transfer Pricing: A Management Accounting Approach within the Banking Industry - JENNIFER D. RICE - - MEHMET C. KOCAKULAH - Transfer Pricing Capital - ALEXANDER KIPKALOV - To FTP Or Not To FTP - That Is The Question! - W.RANDALL PAYANT, CRP - Volume 22, Number 2

2 The Journal of Performance Management seeks articles from management information professionals on subjects related to management information in the financial servides industry. Manuscripts should be typed with double spacing and generous margins. Please contact AMIfs for complete Manuscript Guidelines prior to submitting your article. Submit manuscripts to: AMIfs Saffron Circle Carmel, IN (317) FAX: (317) Web: All articles in the Journal reflect the views of the authors and should not be construed as the opinions of the Association for Management Information in Financial Services. Contributing authors are required to sign a copyright agreement. AMIfs Research Committee Jeff Nathasingh, BBVA Compass, Chair Greg Fitzgerald, AmTrust William Di Filippo, Frost Bank Chris Rebant, Huntington The Research Committee can be contacted by at Research@amifs.org For a complete list of previous Journal issues, refer to the AMIfs web site at Orders for previous issues may be placed directly on the website under the Education page. Copyright 2009 by the Association for Management Information in Financial Services. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher.

3 Table of Contents Prologue... 2 Best Practices & Strategic Value of Funds Transfer Pricing ORLANDO B. HANSELMAN - Funds Transfer Pricing: A Management Accounting Approach within the Banking Industry JENNIFER D. RICE - - MEHMET C. KOCAKULAH - Transfer Pricing Capital ALEXANDER KIPKALOV - To FTP Or Not To FTP - That Is The Question! W. RANDALL PAYANT, CRP - ASSOCIATION FOR MANAGEMENT INFORMATION IN FINANCIAL SERVICES TABLE OF CONTENTS 1

4 Prologue THE ORGANIZATION The Association for Management Information in Financial Services (AMIfs) is the preeminent organization for management information professionals in the financial services industry. Founded in 1980 (known then as NABCA), AMIfs has become the premier organization of its type, and counts among its members individuals who set the policies and advance the concepts of management information at major financial institutions worldwide. ASSOCIATION MISSION AMIfs is a not-for-profit professional association dedicated to developing and advancing the profession of management information for the financial services industry. Its goals are: Leadership: Develop opportunities for members to advance the profession by participating in the Association. Research: Identify and coordinate research activities that support the goals of the organization and advance the profession. Education & Training: Provide professional development opportunities for industry practitioners. Networking: Provide opportunities for members to interact and share experience, knowledge, and insights. Other Member Services: Provide related services that add value to membership. Infrastructure: Establish and maintain an organizational structure designed to accomplish the Association s mission through ongoing involvement of industry professionals. JOURNAL OF PERFORMANCE MANAGEMENT 2

5 Best Practices & Strategic Value of Funds Transfer Pricing Transfer Pricing Orlando B. Hanselman Education Programs Director Risk & Performance Solutions Fiserv About the Author: Described by clients as a dynamic profitability and performance management speaker, Orlando B. Hanselman teaches and consults with financial institution executive and board teams throughout the world. In all areas of strategic planning, optimization of risk and profitability performance, asset/liability management, economic capital and funds transfer pricing, Orlando provides clients with an ability to understand easily and apply effectively tactics to improve risk-adjusted returns. Clients acclaim Orlando s straight forward practical solutions and strategic orientation, emphasizing that his combination of knowledge and enthusiasm are second to none. Recognizing great results, clients tout Orlando s expertise, creativity and integrity. The Education Programs Director for The Institute at Fiserv Risk and Performance Solutions, Orlando may be reached at orlando.hanselman@fiserv.com. Executive Summary: Do you know where your profits come from? Do you know which products or customers create value for the financial institution ( FSI ) and which destroy it? Sadly, most FSI today do not have the measured answers to these questions. And too often the intuitive answers are at best misleading or frequently wrong. Currently most FSI simply price loans and deposits to mimic their competitors, who generally have different strategies, goals, risk tolerances and cost structures. Increasingly, however, high performance FSI wishing to create a winning competitive advantage use matched-term funds transfer pricing ( FTP ). These high performance financial institutions use FTP s insights to create strategic value and optimize net interest margins. This article discusses the basics of matched-term funds transfer pricing. Current FTP best practices used by FSI world-wide, introductory insights into FTP s strategic value and tips for getting started are also covered. Financial institutions ( FSI ) eagerly seeking a competitive advantage understand and pursue the substantial strategic benefits derived from best practice matched-term funds BEST PRACTIVES & STRATEGIC VALUE OF FUNDS TRANSFER PRICING 3

6 transfer pricing ( FTP ) at the instrument level. Matched-term FTP is widely embraced by high performing FSI that recognize it as a critical path to enlightened risk and return net interest margin analytics as well as key to optimize margin performance. These high performance FSI comprehend the truth that you cannot effectively manage without measured insights. Roles and Strategic Benefits Funds transfer pricing is an internal management information system and methodology designed to allocate the net interest margin between funds users, such as lenders and investment officers, and funds providers, including branch deposit gathers and the treasury function. Equally true and more pragmatic is the definition of FTP as a rigorous measurement and pricing method based upon the pretense that all funds are bought and sold in an open market. Best practices matched-term FTP establishes a framework for this net interest margin allocation process by incorporating this market pretense concept. Since FTP fosters improved understanding and valuable strategic insights related to the single largest contributor of a FSI s financial performance, the net interest margin, its importance cannot be over emphasized. Increasingly FSI executives acknowledge FTP as the most essential component of a well developed and comprehensive profitability measurement system. Matched-term FTP is the only path to measuring, understanding and effectively managing customer profitability. Simply put, a FSI cannot measure customer profitability without a sound and proven net interest margin allocation methodology as provided by instrument level matched-term FTP. A best practice FTP system is both a risk and return analytical tool. With a well designed FTP system, a FSI will be able to: JOURNAL OF PERFORMANCE MANAGEMENT 4

7 Measure business unit, product and customer profitability. Measure and segregate net interest margin risk components. Achieve improved net interest margin accountability and segregation of duties. Develop a sound basis for optimal customized loan and deposit pricing. Institute improved risk-based product pricing with higher net interest spreads. Highly successful executives have always understood the fundamental management truths that you cannot manage something if you do not measure it and if everyone is accountable for an important performance factor no one is accountable. Matched-term FTP adheres to these fundamental management truths. The Basics Financial instrument by financial instrument, each source of funds, such as a deposit or borrowing, and each use of funds, such as a loan or investment, are valued at the time of their origination. This valuation is accomplished by assigning each financial instrument an associated transfer rate from an appropriate transfer curve(s). The associated transfer rate mirrors as closely as possible the underlying financial instrument s cash flows, repricing and optionality attributes. This assigned transfer rate is then wed to the financial instrument and does not change until the financial instrument either matures or reprices. The allocation of the FSI s net interest margin is accomplished by this instrument by instrument valuation. With this instrument level processing, the FSI effectively aggregates FTP results at the total organizational level as well as at the business unit, product and customer levels. Assigned transfer rates must match the financial instrument as closely as possible. Cash flow, repricing and maturity of the instrument will be used to determine the BEST PRACTIVES & STRATEGIC VALUE OF FUNDS TRANSFER PRICING 5

8 appropriate point on the transfer curve(s) to find the transfer rate. While indeterminate maturity financial instruments such as credit cards, open lines of credit and checking accounts pose an additional challenge, several best practice methods for effectively estimating their maturity have emerged and become well accepted within the industry. If the underlying financial instrument has a fixed rate, the transfer rate should be a fixed rate. Adjustable rate financial instruments should have a transfer rate which changes upon the instrument s reset date. Floating rate instruments should have a floating transfer rate. Financial instruments that amortize should have a transfer rate that considers amortization. And finally, if the underlying financial instrument allows for prepayments or early withdrawals, the transfer rate should do the same. In selecting transfer curve(s) some FSI use one curve for all assets and liabilities, while others prefer multiple curves dependent upon the specific nature of their different assets and liabilities. FSI opting for one curve for the entire balance sheet generally assess their tendency to be either asset or liability heavy and select the curve to correspond to their positioning. Using more than one curve may introduce an element of basis risk due to the possibility of fluctuations in the spread between either the asset or the liability transfer curves. This concern is largely mitigated since the process of matched-term FTP effectively isolates interest rate risk, including such created basis risk, to the centralized funding center. It is the funding center which earns a mismatch spread as a return for responsible management of the FSI s aggregate interest rate risk. Acceptable market-driven curve choices include those associated with government investments and bonds, LIBOR, advance borrowings offered by governments and their agencies, SWAPS, commercial paper and brokered deposits. Some FSI even construct a curve based upon a combination of these choices such as use of an overnight government JOURNAL OF PERFORMANCE MANAGEMENT 6

9 rate at the shortest end, commercial paper for the intermediate term and government advances for the long-term. No one right answer has yet emerged as best practice in choosing a FSI s fund transfer pricing curve(s). Each option presented has both strengths and weaknesses. Intelligent selection of funds transfer price curve(s) must, however, encompass our agreed-upon FTP market pretense definition as well as embrace certain critical characteristics related to optimal curve(s) choice. Four critical curve(s) characteristics are generally accepted: 1. Curve(s) should represent the opportunity cost or benefit of the funds. 2. Curve(s) should represent marginal wholesale rates. 3. Curve(s) should be derived from reliable and readily available data sources. 4. Curve(s) should be credible as well as understood by and acceptable to FTP users such as lenders, investment officers, liquidity managers, branch deposit gatherers and treasury personnel. Many FSI, based upon this conceptually sound thought process, utilize two curves best tailored to their unique business model of incremental funds deployment and procurement: a market-based alternative investment curve for deposits and borrowings and a market-based alternative liquidity funding source curve for loans and investments. This curve decision is sound in definition and characteristics, practical and realistic in design and allows simple execution for the entire balance sheet. To ensure the transfer rate best mirrors the cash flow of the underlying financial instrument, FSI generally use a strip funded methodology (FIGURE 1). Each principal cash flow, unadjusted for prepayment or early withdrawal, is valued separately on the transfer curve to arrive at a blended transfer rate. For example, a six year $20,000 BEST PRACTIVES & STRATEGIC VALUE OF FUNDS TRANSFER PRICING 7

10 amortizing loan with an 8.0% interest rate would be wed to a blended transfer rate of 4.9%, representing a composite of six different points on the transfer curve at loan origination, each point reflecting the annual principal repayment cash flows. Using this strip funded methodology provides a better matched transfer rate more closely mirroring the financial instrument s cash flows, giving full consideration of the yield curve shape of the market-based transfer curve. Accordingly, the strip funded methodology best captures both the cash flow as well as the economic market reality at loan origination. Figure 1 The matched-term FTP method is performed financial instrument by financial instrument at the time of the instrument s origination. The net interest margin is allocated by assigning notional transfer rates to all fund sources and uses. This process determines transfer expense related to assets such as loans or investments and transfer income related to funding liabilities such as deposits and borrowings. Only through this process is the well understood and accepted economic value of customer deposits and FSI branches measured and recognized. JOURNAL OF PERFORMANCE MANAGEMENT 8

11 Generally speaking, when a loan is originated the transfer rate is established by locating on the selected transfer curve the corresponding term point, or points in the case of the recommended strip funded approach. This matched transfer rate or blended transfer rate derived from the curve is then wed to the underlying financial instrument. Our FIGURE 2 example shows a one year loan with a rate charged to the customer of 7.25% wed to a 5.25% transfer expense rate, representing the market-based incremental funding cost. This 2.00% difference between the rate negotiated with and paid by the borrower and the transfer rate is the credit spread. Credit spread is earned by the lenders for assuming credit risk and it must be adequate to compensate for: credit losses; direct operating costs related to the lending operations and loan servicing; and general allocated FSI overhead. This net credit spread must also generate an adequate profitability return. Figure 2 BEST PRACTIVES & STRATEGIC VALUE OF FUNDS TRANSFER PRICING 9

12 Likewise, for a deposit account the appropriate point on the selected transfer curve is located to match the underlying financial instrument. Our FIGURE 2 example shows a 3 month 3.25% customer certificate of deposit matched to a transfer income rate of 4.25%, representing the market-based incremental value of the funds provided. This 1.00% difference between the transfer income rate and the deposit rate paid to the customer is known as the deposit franchise spread. The deposit franchise spread is earned by the branch for cost effectively obtaining retail funding for the FSI. This deposit franchise spread must be adequate to compensate for direct operating costs of the branch and retail delivery systems as well as general allocated credit FSI overhead. This net deposit spread must also generate an adequate profitability return. After every financial instrument has been valued one by one through the FTP system, the remaining difference between all transfer rates is known as the mismatch spread. Our FIGURE 2 example shows a mismatch spread of 1.00%. This mismatch spread is earned by the FSI s funding center. It is the funding center, created as a business unit during implementation of the FTP process, which manages holistically the aggregate interest rate and market risk of the FSI. The mismatch spread compensates the funding center for assuming responsibility for mismatch risk management and must be adequate to cover: direct operating costs of the funding center; general allocated FSI overhead; and hedging or other costs of mismatch risk protection. It must also produce an adequate profitability return. Some FSI elect to make other adjustments to the derived transfer rates including: early withdrawal penalties, reserve requirements and insurance premiums for deposits. prepayment penalties, collateral costs and liquidity premiums for loans. JOURNAL OF PERFORMANCE MANAGEMENT 10

13 Using special product promotions, FSI more effectively reach growth and balance goals by adjusting derived transfer rates to further incent desired business unit and employee behaviors. The FSI s need to rebalance risk exposures, such as lending concentrations, may also be facilitated by temporary transfer rate adjustments. FSI choose to make these elective adjustments based upon their unique strategies, goals and risk tolerances as well as the materiality to the net interest margin of the factors being considered. It is in this manner, financial instrument by financial instrument, that matched-term FTP allocates the net interest margin contribution and establishes improved net interest margin accountability. While every FSI measures and reports their total net interest margin, only those using FTP are able to explain and quantify these three sources of net interest margin contribution: credit spread; deposit franchise spread; and mismatch spread. Improved margin accountability is achieved because we now have three discrete management buckets, each containing segregated risk, return and responsibility. The lender bucket holds assumed credit risk with resulting credit spread return and establishes exclusive lender accountability for managing the FSI s credit risk. The branch bucket holds assumed liquidity risk with the resulting deposit franchise spread return and establishes exclusive branch responsibility for cost effectively obtaining the appropriate amounts of retail funding just in time as needed. And finally, the funding center bucket holds assumed interest and market risk with the resulting mismatch spread return and establishes exclusive responsibility for macro-management of the FSI s interest and market risk. These three buckets provide the FSI with heightened accountability and enhanced segregation of duties. BEST PRACTIVES & STRATEGIC VALUE OF FUNDS TRANSFER PRICING 11

14 As a result of this process, the FSI has now achieved the first critical step in measuring its business unit, product and customer profitability, an allocated net interest margin. Bear in mind, without FTP, a typical branch s income statement is primarily comprised of fee income, deposit expense, overhead expenses and some direct loan income. The major source of a branch s economic contribution to the FSI, which is only measured with FTP, is the deposit franchise spread earned on its generated deposits. Likewise, a lending unit s income statement without FTP is primarily comprised of loan income, credit losses and overhead. Without FTP lending units are not assessed a cost of funding for the loans they make, much akin to selling cars without paying for the steel used in manufacturing. It is only through use of an FTP system that business unit profitability can be properly measured and thereafter appropriately managed. Once each financial instrument has an associated transfer cost or value, product and customer profitability becomes the aggregation of all allocated net interest margin dollars associated with the applicable underlying instruments. Sound Starting Point for Pricing Each FSI may now use these well grounded FTP insights to provide optimal customized loan and deposit pricing. Such optimal pricing begins with the FTP derived cost of funds used or value of funds provided plus consideration of the following elements: Costs of business operations. Goals and strategies. Imbedded transaction risks. These elements are specific to each FSI and should not be ignored when establishing prices. JOURNAL OF PERFORMANCE MANAGEMENT 12

15 Our optimal customized loan price would be determined by this formula: FTP cost of funds used + Fixed and variable lifetime costs associated with the loan + Cost of assigned capital based upon all imbedded risks (credit, interest rate, market, liquidity and operational) related to the loan as well as specific to the customer + Strategic return expected For deposits, the formula for optimal customized pricing would be: FTP value of funds provided - Fixed and variable lifetime costs associated with the deposit - Cost of assigned capital based upon all imbedded risks (interest rate, market, liquidity and operational) related to the deposit - Strategic return expected These FTP based formulae determine a FSI s unique and optimal price which provides an economic risk-adjusted profit as well as book profit at the strategic return rate expected. From this suggested optimal price, further tailored pricing refinements may be considered such as the customer s loyalty and price elasticity as well as specific valueadded product features. The local competitive market as well as the FSI s balance sheet needs and risk positioning must also be considered prior to finalizing the price. Getting Started Some FSI have failed to pursue the significant strategic value offered by FTP because of their lack of knowledge, concerns related to cost and time involved and a mistaken belief that their current measurements are adequate. Shrinking industry net interest margins are accenting the need for FTP. Falling PC-based FTP technology costs are expanding the affordability and scalability of this proven solution. These market factors, coupled BEST PRACTIVES & STRATEGIC VALUE OF FUNDS TRANSFER PRICING 13

16 with high performing FSI s demonstrated FTP success and heightened regulatory demand for better risk-based pricing, resoundingly rebut the rationality of this inaction. Reasonable implementation time is required, however, and like any worthwhile journey it begins with the first step. Four key steps guide this profitable strategic journey: 1. Educate and involve key FSI personnel. While the Chief Financial Officer and the accounting staff are most likely going to lead this journey, it is critical to ultimate success that executive officers and lenders as well as branch, investment, treasury and marketing personnel be actively involved and that they collectively reach a level of comfort and understanding. The return on your FTP investment comes from optimizing the net interest margin with enhanced accountability and pricing sophistication based upon daily effective use and understanding by lenders and branch, treasury and investment personnel. 2. Form a project steering committee including finance and accounting staff as well as key end users. The steering committee is essential to ensure FTP understanding and acceptance, adept project management, involvement, thorough communication and timely implementation. The appointed committee chair should be knowledgeable, respected and unbiased. It is the chair who must freely facilitate discussion to reach accepted consensus on FTP s many choices and assumptions. When consensus cannot be reached in a reasonable timeframe, however, the chair must have the authority and grit to end further fruitless discussion and pronounce a binding decision. 3. Review vendor FTP systems and PC-based models. Your steering committee should select a vendor who provides you with a robust and flexible tool and, most critically, exceptional implementation and post- JOURNAL OF PERFORMANCE MANAGEMENT 14

17 implementation technical support. The software model should accommodate a vast variety of rate adjustments as well as complex financial instrument cash flows. Ideally your FTP model should also promote integrated data and insight sharing between your other profitability measurement, budgeting, risk analytics and performance management software. Vendors must also possess a strong client base and a history of long-term financial industry software leadership. Independent and leading edge education aimed at understanding and utilizing system reports, incorporating data insights into sound winning strategy, and earning an acceptable return on your software investment ( ROI ) is mission critical. Avoid vendors who do not offer this education. 4. Collaborate with your chosen vendor to: a. Decide on the rationale and source of transfer curve(s) b. Gather data and implement a customized FTP system tailored to your strategies, philosophies and goals. c. Produce, analyze and adjust preliminary results. Remember that this will be an evolutionary process of continuous improvement and refinement. Initial reports will require refinements and adjustments. An educated and involved steering committee is essential for success of the project and realization of the ROI. The steering committee should be involved from the very outset until credible reports are being consistently produced and used by line personnel. It is the responsibility of the steering committee to ensure that personnel understand and participate in system design to ensure buy-in. The steering committee must also keep the project progressing, avoiding a costly search for elusive and unnecessary precision. The goal is to produce a fair and realistic assessment of the net interest BEST PRACTIVES & STRATEGIC VALUE OF FUNDS TRANSFER PRICING 15

18 margin contribution as well as credible results for users. Finally, the steering committee must actively employ education and communication to overcome imbedded cultural barriers. Overcoming such barriers is essential to embracing FTP and unlocking its strategic value and ROI. Conclusion The world-wide consensus is that best practice FTP requires assignment of a marketbased contribution value to funds provided and used determined by assessment of each individual financial instrument at the time of origination. It is also essential that your FTP system is understandable, explainable, consistent, well documented and credible with users. Your FTP system must be customized to your unique FSI. High performance FSI wishing to create a winning competitive advantage use FTP s insights to create strategic value and optimize net interest margins. They recognize that FTP is a critical path to enlightened risk and return net interest margin analytics and is key to optimizing the margin. Begin your profitable journey on this proven path today. (This article originally appeared as Intelligent by Design: Selecting Funds Transfer Pricing Curves to Optimize Margins as the cover in the April 2008 Bank Asset/Liability Management issue. In May 2008 CUES FYI published a two part serial as What s the Right Transfer Rate and Getting Started with FTP. The third part of the serial was later published in the June 2008 Credit Union Magazine as Funds Transfer Pricing.) JOURNAL OF PERFORMANCE MANAGEMENT 16

19 Funds Transfer Pricing: A Management Accounting Approach within the Banking Industry * Jennifer D. Rice, Old National Bancorp jennifer_rice@oldnational.com Mehmet C. Kocakulah* Department of Accounting and Business Law School of Business University of Southern Indiana, Mkocakul@usi.edu 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 margin 1, which typically serves as the traditional banks largest source of profitability 2 (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 1 Net Interest Margin is defined as net interest income (interest income less interest expense), on a tax equivalent basis, expressed as a percentage of average earning assets. FUNDS TRANSFER PRICING: A MANAGEMENT ACCOUNTING APPROACH WITHIN THE BANKING INDUSTRY 17

20 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 2 According to R. Kimball in the New England Economic Review, net interest margin ranges between 60 to 80 percent of bank revenue. JOURNAL OF PERFORMANCE MANAGEMENT 18

21 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 market 3 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 (AMIfs 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. When implementing a FTP system, banks must determine a funding curve that most reflects their source or use of funds on the wholesale market. Some banks may utilize an interbank rate such as LIBOR (London Inter-Bank Offer Rate)/SWAP rates or a common rate index such as United States Treasuries. The funding curve, simply plots the relationship between time to maturity and yield to maturity for a given type of financial instrument (Hogan Systems Inc., 2000). An example of a funding curve is show below in Exhibit 1. 3 Typical sources of wholesale funding include federal funds, Federal Home Loan Bank (FHLB) borrowings, brokered certificate of deposits, and borrowings from other financial institutions. FUNDS TRANSFER PRICING: A MANAGEMENT ACCOUNTING APPROACH WITHIN THE BANKING INDUSTRY 19

22 Exhibit #1 SWAP Rates as of March 15, 2002 Rate 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 12 Month LIBOR 2-year Swap 3-year Swap 5-year Swap 7-year Swap Maturity 10-year Swap 15-year Swap 3/15/2002 Often, adjustments are made to the base-funding curve to reflect a customized curve for an individual institution. Also, adjustments are made to reflect the banks financial condition and its industry ratings, thus impacting how closely the institution can borrow funds at the market costs on the base curve. Common adjustments to the base-funding curve include liquidity (i.e., how easily the account can be converted into a more liquid investment) adjustments and option pricing adjustments (i.e., because customers have the right to pay off their loan or redeem their deposit at no charge before the contractual maturity date). Banks must decide how often funds transfer pricing rates should be assigned. The frequency of FTP rate application is often determined based upon the limitations within a bank when collecting their data. FTP rates may be updated as frequently as real time, daily, weekly, or monthly. Before implementing a funds transfer pricing system within a bank, management must be educated on the processes and buy in on the benefits of the internal management system. In addition, all employees must be educated on the functionality of the system. They must also be educated on how to use FTP when making their pricing decisions. JOURNAL OF PERFORMANCE MANAGEMENT 20

23 Using Funds Transfer Pricing to Improve Profitability Banks utilize funds transfer pricing to improve their pricing decisions and overall profitability. FTP can be used as a means of accountability for all lines of businesses within a bank. In addition, funds transfer pricing can be used to hold employees accountable for their pricing decisions because an individualized FTP rate is applied at the transaction account level. FTP is used to identify, measure, monitor, and create management accountability for the components of net interest margin based on the inherent value and risks associated with the gathering and eventual use of funds in the financial intermediation process (AMIfs Research Committee, 2001). An alternative approach to funds transfer pricing is managing a banks net interest margin strictly through the all in yield paid to or received from the customer. However, focusing on the yield and not the costs of funding the products is the same as a sales manager focusing solely on revenues and not the expenses associated with his or her sales. Banks must take into consideration their costs of funds in order to control their net interest margin and ultimately their net profit. In addition, banks that focus strictly on yields are not managing their interest rate risk. Interest rate risk is created because of the different characteristics (i.e. rate change frequency, terms, etc.) of the sources (deposits and wholesale funds) and uses (loans and investments) of funds within their institution. Funds transfer pricing enables banks to prepare profitability analyses, specifically for their net interest margin, for each of their business lines. FTP measures profitability down to the individual product and customer level (Coffey, 2001). Funds transfer pricing provides management with valuable information that will aid them in making sound business decisions with the goal of increasing net income and shareholders return. FTP can be used as a FUNDS TRANSFER PRICING: A MANAGEMENT ACCOUNTING APPROACH WITHIN THE BANKING INDUSTRY 21

24 foundation to quantify the profitability of an entire customer relationship (i.e. loans, deposits, and other banking services). When a funds transfer pricing system is implemented effectively within a bank, the institution can break down their net interest margin contribution into loan contribution, deposit contribution, and interest rate risk. The following example illustrates how FTP aids banks in the analysis of their profitability. Average Yield on Loans* 8.0% Cost of Deposits** 5.0% Net Interest Margin 3.0% *Average life of 8 Years; Cost of funding was 7% **Average life of 2 Years; Cost of funding was 6% Average Yield on Loans 8.0% Average Cost of Funds 6.0% Average Cost of Funds 7.0% Average Yield on Deposits 5.0% Average Spread to FTP 1.0% Average Spread to FTP 1.0% The 3% net interest margin is composed of 1% net interest margin on loans (8% less 7%), 1% net interest margin on deposits (6% less 5%), and 1% net interest margin on interest rate mismatch (7% less 6%). The income from the interest rate mismatch is generated because of the difference between funding loans with eight-year average lives by deposits with two- year average lives. Although this interest rate mismatch has created additional earnings for this institution, excess amounts often create unwanted risks. In order to better manage the interest rate mismatch, banks typically create a business unit that is responsible for monitoring and JOURNAL OF PERFORMANCE MANAGEMENT 22

25 managing the interest rate risk. Banks do not have the ability to easily eliminate their interest rate risk mismatch in its entirety. When funds transfer pricing is implemented within a bank, it is critical that adequate management reports are created and distributed within the institution. Often institutions only provide reports to top management at a very high level of detail. It is important to provide management with reports that are useful for their future decision-making processes. Exhibit #2 illustrates how banks can compare their different operating units for new production on loans. The graph depicts the spread to FTP (yield paid to bank less the cost of funding the loan) on all new loans booked over the past three months. Executive management can use this information to analyze what caused the decline in spread for Region #1 and Region #3 during the month of March This information should be used to prevent the decline in spread for future months. Exhibit #2 Total Loans-Monthly Production Weighted Average Spread (%) Jan-02 Feb-02 Mar-02 Month Region #1 Region #2 Region #3 In order to improve net interest income within a bank, senior management can hold their individual employees accountable for their funding spreads. Bank employees can be given the ability to review the profitability of all accounts that they originate. An example of a detailed report is found in Exhibit 3. Funds Transfer Pricing - Certificates of Deposit Exhibit #3 FUNDS TRANSFER PRICING: A MANAGEMENT ACCOUNTING APPROACH WITHIN THE BANKING INDUSTRY 23

26 Officer Account Origin Maturity Code Branch Number Balance Yield FTP Spread Date Date , % 7.58% 1.99% 6/10/2000 6/10/ % 7.42% 1.93% 7/19/2000 7/19/ , % 3.69% 0.09% 9/1/2001 9/1/ , % 7.05% 2.05% 9/7/1999 9/7/ , % 7.80% 2.40% 5/30/2000 5/30/ , % 7.30% 1.81% 8/12/2000 8/12/ , % 7.05% 2.05% 9/21/1999 9/21/ , % 5.77% 0.86% 2/1/2001 5/1/ , % 5.38% 0.86% 3/1/2001 6/1/ , % 5.38% 0.86% 3/2/2001 6/2/2002 It is important to note that the information provided within Exhibit 3 includes the officer code of the employee who booked the certificate of deposit. The profitability of the certificate of deposits shown in this exhibit range from a spread of 0.86% to 2.40%. Banks may chose to link their incentive programs to their spreads to FTP. For example, a customer service representative may be offered a monetary incentive to originate a certificate that exceeds their targets for the year. According to Randall T. Kawano, 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 (Kawano, 2000). However, before integrating FTP within incentive programs, a bank must ensure they have carefully created effective programs that will not promote behavior that is not in the best interest of the bank as a whole. Funds transfer pricing serves as the first step in analyzing profitability within a financial institution. According to Ralph Kimball, while funds transfer pricing systems were a great step forward, both in disaggregating the net interest margin and in identifying and managing bank exposure to interest rate risk, they are not sufficient in and of themselves to calculate organizational profitability (Kimball, 97). Activity-based-costing (ABC) serves as an excellent addition to the funds transfer pricing methodology. ABC aids banks in better understanding the JOURNAL OF PERFORMANCE MANAGEMENT 24

27 business process and the activities that constitute it. For example, when a loan is originated and funded, the cost of funding the loan is not the only cost incurred by the bank. The bank must process the loan application, prepare loan documentation, mail documents, and pay salaries to all employees involved in the loan preparation process. Using Funds Transfer Pricing for Budgeting and Planning Banks can improve their planning processes by integrating funds transfer pricing into their methods. Not only does this reinforce the importance of FTP within an institution, it also eliminates the banks requirement to estimate future interest rates. A banks treasury department typically holds the responsibility for forecasting future interest rates and economic condition. Each year, banks prepare an annual budget that estimates net interest margin by profit and cost center. When senior management meets with their divisions concerning the budget, they will discuss their expectations of volumes and profitability. Rather than quantifying the yields that will be received on new loan production or paid on interest bearing deposits, the divisions should plan their spread to FTP for their new business production. Because they will be planning a profit spread and not an all in rate, they should be able to make better decisions and meet budget in a changing interest rate environment. It is important for budget variance analyses to be completed monthly in order to provide adequate information for decision-making purposes. Summary/Conclusion Funds transfer pricing is a very important management accounting tool used within the banking industry because it helps banks make profitable decisions. FTP provides a quantitative means to measure customer profitability and should be used in the performance evaluations of FUNDS TRANSFER PRICING: A MANAGEMENT ACCOUNTING APPROACH WITHIN THE BANKING INDUSTRY 25

28 business units. When implemented and used effectively, FTP will help increase a banks ability to monitor and improve its net interest margin. Bank employees can be rewarded for collecting customer deposits that are less expensive than the banks wholesale funding costs. In addition, loan officers can be rewarded for originating profitable loans, those that have a positive spread to the banks cost of funds. Ultimately, management and employees must be well educated and accepting of funds transfer pricing in order for it to be successful within an institution. References AMIfs Research Committee, Assignment of Contribution for Funds Transferred Internally, Journal of Bank Cost & Management Accounting, 2001, Volume 14, Number 3. Coffey, John J., What is fund transfer pricing? Bank Marketing, November 2001, Volume 33, Issue 9. Hogan Systems, Inc. with contributions from Cole T. Whitney and Woody Alexander, Funds Transfer Pricing: A Perspective on Policies and Operations, Journal of Bank Cost & Management Accounting, 2000, Volume 13, Number 3. Kawano, Randall T., Funds Transfer Pricing, Journal of Bank Cost & Management Accounting, 2000, Volume 13, Number 3. Kimball, Ralph C. Innovations in Performance Measurement In Banking, New England Economic Review, May/June 97. * This article was previously published in the Journal of Performance Management in Volume 17 #2. JOURNAL OF PERFORMANCE MANAGEMENT 26

29 Transfer Pricing Capital * By Alexander Kipkalov, Recent dramatic interest rate volatility has created problems and attracted significant attention to Funds Transfer Pricing methodology one of the fundamentals of performance measurement in the financial services industry. The ensuing, and sometimes emotional, discussions among performance measurement and ALM practitioners have mostly been concentrated around how to transfer price deposits and explain the volatility in the funding unit s income. They have also questioned some basic principles of FTP used by institutions for many years. With the accelerated development of internal Economic Capital (EC) techniques boosted by the Basel II Accord, transfer pricing of allocated capital became a hot topic too. This issue is particularly important for institutions with significance interest rate risk exposure like thrifts or banks with large mortgage portfolios. By design, FTP reduces or eliminates volatility of the interest margin in the business units and concentrates it in the Funding Unit, thus creating a potential for material income or loss position. Incorrect FTP treatment of EC can change profitability of the product, business line or a customer, but more importantly, it can create material volatility of the Funding Unit s income. Economic Capital has a strong inherent relationship with FTP methodology. Both are based on the desired credit rating of an institution or a portfolio 1. A company with an A+ credit rating will use A+ senior/subordinated debt rates as its funding curve. The rating will also determine the confidence interval for economic capital allocation. FTP and EC both share a market risk component. FTP extracts most of the interest rate risks from business lines and aggregates it in the Funding Unit. This risk should be measured and managed centrally. If a company makes the decision to leave some types of market risk 2 in the business units, economic capital should be attributed to the units for these risks. EC is a measure of risk, but it is also used to calculate how much of a company s equity should be allocated for the risk. This allows us to treat EC as a proxy for allocated equity. FTP methodology ensures that the Funding Units pays a credit to the providers of funding sources. These sources of funds include deposits, other borrowings and equity. As a source of funds, equity, and correspondingly, EC should receive an FTP credit. The amount of the credit and the calculation method relies on the FTP methodology adopted by an institution. We recommend using the Cost of Funds Reduction approach because it is simple, elegant and the most efficient to implement. 1 Some institutions make decision to assign lower cost funds for portfolios in order to achieve competitive advantage in pricing. In this case capital allocated will be higher. For example portfolio funded with AArated curve would have to hold capital at AA confidence level. 2 For example, Convexity, Basis, Vega etc. TRANSFER PRICING CAPITAL 27

30 Performance Metrics and Funds Credit for Capital To measure performance, whether of a business unit, product or a customer, we must calculate return relative to the size of investment, and to the risk contributed by the investment. The latter is measured by Economic Capital (EC). This risk/return relationship is the basis for multiple performance metrics. Measuring EC s effect on the return through FTP can shift the relationship significantly, particularly in the case of high-risk assets. In this section we will briefly describe principles of the two performance metrics that will be used in illustrating the different ways of transfer pricing capital. There are two main categories of performance metrics used by financial institutions. One is based on the ratio of modified return to the level of risk (RAROC, RORAC, ROEC) 3, another is based on considering earnings over and above the shareholder s required return allocated for the level of risk (SVA, NIACC, EP) 4. We will use Risk Adjusted Return on Capital (RAROC) to illustrate the concept of the capital credit. RAROC = (NII OE EL)*(1-T) EC Where: NII Net Interest Income OE Overhead Expenses EL Expected Credit Loss T- Corporate Tax EC Economic Capital As long as RAROC exceeds the shareholder s required return or hurdle rate, the investment increases profitability and return to the shareholders. The largest variable in the RAROC equation is Net Interest Income (NII): that is, the interest income from assets, interest expense required to finance the asset, and any additional income provided by the attributed economic capital. The origin and size of this latter portion - income from the attributed EC - is at the center of the disagreement among FTP practitioners. We came across at least three methods of calculating the FTP credit on EC used by financial institutions: (1) duration of allocated equity, (2) investment and (3) a cost of funds reduction. Although all three stem from the same underlying idea, each one can lead to different results. We consider the last one (funding cost reduction) the most accurate and straightforward. 3 RAROC Risk Adjusted Return on Capital; RORAC- Return On Risk Adjusted Capital; ROEC- Return on Economic Capital. 4 SVA-Shareholder Value Added; NIACC-Net Income After Cost of Capital; EP- Economic Proft. JOURNAL OF PERFORMANCE MANAGEMENT 28