In any bank, the Treasury Department acts as “the bank’s bank”: deposits taken by the commercial departments are transferred to Treasury, who in turn make the money available either to lend out to the bank’s customers, or to invest in other financial instruments such as Treasury Bills. If there is a shortfall in cash, the Treasury department has to fund this shortfall; if there is an excess (surplus) of cash, Treasury must invest it. The capital associated with a bank’s interest bearing products (both assets and liabilities) have a cost associated with them: the costs associated with these activities are called “Funds Transfer Pricing” (FTP), as it reflects how funds are transferred to and from the Treasury department to the various business units. The costs are reflected in the FTP rates associated with the products offered by the bank. These rates are of relevance internally to the organisation and are different to the rates earned/charged from the external dealings in the products. From the principal amounts and FTP rates, “FTP interest” is calculated. This makes it possible for the bank to separate a product’s FTP interest from its commercial interest (which is based on the products’ external interest rates). Another way to rephrase this is that FTP looks at what the bank’s commercial cost of funds are (i.e. getting their funding from deposits), vs what the cost would be if those funds were raised and invested in the market.
FTP Methodology
The Riskflow approach to Funds Transfer Pricing (FTP) is that of matched maturity, referred to as Matched Funds Transfer Pricing: to determine the transfer (internal) price, the time from origination to maturity of any deal is used to determine the rate. Once priced (at origination date), a loan (or term deposit) does not get repriced in subsequent periods. This is done in line with the concept of “original maturity matching” and ensures that Interest Rate Risk is transferred from the commercial departments (who have no control over movements in market rates) to the Treasury. These internal (FTP) rates used to price the product need not necessarily be market rates. However, most banks often use a SWAP curve such as LIBOR as the internal (FTP) curve. Before determining the commercial (external) interest earned on loans, our data extracting repository first classifies each loan as “Performing” or “Non-performing”, as only performing loans are deemed to generate income. This ensures that Credit Risk is transferred from the Treasury (who have no control over client behaviour) to the commercial departments who are responsible for ensuring that customers repay their loans.
Results
The FTP report calculates the bank-wide Net Interest Income (NII) and breaks it down in terms of which portion is attributed to the commercial side of the bank (the so-called “Asset Margin” and “Liability Margin”) and what comes from Treasury (known as the “Mismatch Margin”). The reported rates are weighted rates (with rates of each account proportionally weighted against the amount of capital in the account). The curves are defined by a set of daily points (i.e. 1 day, 91 days, 182 days, 365 days, 2 years, 5 years, 10 years etc). The system uses linear interpolation to price curve. The FTP report breaks down results as:
- Bank Interest (@rate charged to the client) = Asset Margin+ Liability Margin
- FTP Interest (internal cost of funds) based on FTP Rates
- Mismatch (Treasury) Margin= Commercial Interest- Internal Funding costs
- Nett Interest Income= Asset Margin+ Liability Margin + Treasury Margin
The report can further break down the assets and liabilities by business unit, branch, product, currency or country to measure effectiveness and profitability and therefore assist in the allocation of capital according to the principle of Economic Capital.
Data Requirements
Funds Transfer Pricing is a module of the Treasury Platform and cannot run as a stand-alone solution (or receive data from any source other than the data repository within the platform). The application needs a set of account level information for loans, non-time deposits, time deposits and overdrafts that have already been priced (i.e. data is taken on with pre-priced contracts). Alternatively, the book as at a particular time can be priced based on a specified set of pricing curves. The account level information must be imported in each subsequent month, to price new loans and term deposits. Spreadsheets containing the curves for pricing Assets and Liabilities must be supplied each month. These represent the rates at which Treasury would have obtained or invested funds in the market (if there was a funds shortage or surplus). It is possible to use the same curve for all products. A simple FTP model typically uses the relevant SWAP curve (e.g. LIBOR) for both sets of transfer prices.
Mechanics
Firstly, the relevant pricing curves are updated to reflect the current period’s curves. Next, the current month’s account level information is imported into the system. The system checks to see if there are any new (unpriced) loans or time deposits and then it prices them according to the defined pricing curves. New loans and deposits get added to the system’s pricing table. The non-time deposits get priced off the 1-day liability curve and then the whole non-time book gets added to the “priced” table (i.e. non-time deposits are repriced monthly). From here the MFTP report is generated.