FTP: effective management towards clarity

The possibilities and limitations of funds transfer pricing

FTP: effective management towards clarity

Achieving a positive interest margin – the profit created by lending at a higher interest rate of interest compared to the borrowing rate – is one of the pillars of a bank’s business model. The total interest result is easy to measure, but to what extent do the departments that raise money and provide financing contribute to that? A funds transfer pricing (FTP) framework can help provide insight into that, but also involves a number of challenges.

The various commercial departments in a bank (mortgages, savings, etc) have an impact on their result via the pricing and terms & conditions of the products they offer. However, the interest rate and liquidity risk that arises from these products is often managed by a central treasury. The total profit depends on the collective performance of all the departments. Insight into the economic value creation and risk contribution per department or product is crucial in order to effectively manage a bank. This can ultimately be used to improve the balance sheet, so the bank’s capital can be put to optimal use. Furthermore, the Dutch central bank (DNB) also requires this insight as part of the ILAAP (Internal Liquidity Adequacy Assessment Process) guidelines.

FTP product result build-up

Figure 1: Product result build-up

Margin

An FTP framework contributes to this insight by setting a transfer price for the funds that commercial bank departments raise and lend. This price consists of (risk-free) interest costs and liquidity costs. The treasury charges this predetermined fixed price to the departments, after which the impact of changing market conditions is entirely at the treasury’s expense. This enables direct insight into the product margin.

FTP example result seperation

Figure 2: Example result seperation

Advantages

FTP provides direct insight into the profitability of products, both for management and departments. Since a price is agreed on in advance, the department result is not obscured by changes in the financing costs. The framework furthermore creates a clear benchmark: the product is expected to make a loss if the customer interest rate when purchasing a new product does not exceed the sum of the FTP rate and the other expected costs. In addition it provides insight after the fact into the profit realized by comparing the result to the FTP rate. The framework also makes it possible to manage the bank balance sheet by adjusting the FTP price.

By adjusting the FTP price for certain product types and terms with a markup or discount, it is possible to price certain products more attractively and as such bring the terms of the assets and liabilities into balance (see box text). FTP can therefore simultaneously serve as a management and monitoring tool.

An FTP framework also facilitates management of departments on the basis of financial ratios such as the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR), by adjusting the FTP rates via markups and discounts. A robust elaboration of this is complex, however, and falls outside the scope of this article.

 

Challenges

Several aspects must be taken into account in order to effectively implement FTP. The FTP rate is often derived from the rate at which the bank can raise new debt financing via the financial markets, for instance. These costs cannot always be easily determined for all desired terms, however, in particular for companies without publicly traded debt instruments.

Since the determination of the cost price in an FTP framework has a major and direct impact on the results, all departments have an incentive to influence the FTP price. That is why it is important to draw up a clear policy on how the FTP curve and incentivizing markups and discounts are set. Both the treasury and the management board must be involved in this.

The management must also be aware of implicit incentives created by the FTP. Even with an FTP curve without markups, there is an inadvertent control effect: as long as a product is profitable, departments have the incentive to sell as much as possible. Sometimes this is not consistent with the policy objectives. Efficient management therefore requires that an FTP framework be combined with balance sheet limits.

Finally, the technical implementation entails significant costs. These costs depend largely on the FTP method selected. The advantages and disadvantages of the possible methods are worked out in detail in the next section.

Elaboration of choice

Prepayments are a significant risk factor for banks, in relation to mortgages for instance. Because this risk is not by definition the treasury’s responsibility, it may be desirable to pass on the impact of unexpected repayments to the commercial departments. The set-off method chosen determines to what extent this is possible.

With the relatively simple product FTP, an FTP rate is determined once per product, on the basis of the expected cash flows. With the advanced internal contracts FTP, the bank departments enters into internal financing contracts with the central treasury at prices set in advance. The example in the box below illustrates how both methods work and how they deal with prepayments.

Internal contracts allow FTP to explicitly and effectively cope with the impact of early repayments. Without these contracts, only the loss in (interest) income will be included as standard in the department results. There is no direct solution for the loss margin mentioned earlier. This remains with the treasury, if there is no ad hoc penalty

Conclusion

An FTP framework can provide clear insight into the results of bank departments. When introducing this framework, however, the complexity of the implementation and the incentives entailed by the system must all be taken into account. A transfer pricing method with internal contracts provides for the best insights ex-ante and optimal profit attribution ex-post. This enables effective monitoring of which products and departments are expected to be profitable and which indeed prove to be profitable.

FTP significantly increases the transparency of how results are achieved and is therefore a valuable instrument for control and monitoring.

Example

A bank issues a two-year linear mortgage of N100,000 with annual interest payment of 4%, whereby the customer is expected to pay off half of the principal each year. There are no penalties for early repayments. Based on the prices at which the bank can raise funds and the expected repayment behavior of the customer, the FTP rates for one and two-year financing are set at 2% and 3%1, respectively. The other costs for the department equal 1% of the outstanding principal. For this mortgage, according to the ‘matched funding’ principle, half of the amount is financed on a twoyear basis and the remaining half on a one-year basis. At a bank with an FTP framework without internal contracts, the FTP rate is set on product level. This price is calculated as the IRR (internal rate of return) of the expected cash flows. The coupons are calculated on the basis of the FTP rates. In this example that is 2.7%2. At a bank with an internal contracts FTP, the department concludes a one-year and a two-year contract with the central treasury at the prices mentioned below (figure 3).

Product FTP versus Internal contracts FTP

Figure 3: Product FTP versus Internal contracts FTP

Although the value of the mortgage is identical under both methods, the allocation of the result over time is different. With a normal interest rate curve, as in this example, the interest income (expressed as a percentage) remains the same, while the financing costs (expressed as a percentage) increase as time goes on. FTP with internal contracts is able to include this effect in the results.

Now imagine that the interest rates on the market decrease. The one-year financing rate is now 1%. Because of the lower interest rate environment the customer repays 80% of the principal after one year, rather than the expected 50%. Because of the extra early repayment the treasury must put N30,000 back on the market for one year. The return is now only just 1%, and the bank has a loss margin of 1% on that amount (after all, it was raised at 2%). Who will cover this loss?

The FTP system with internal contracts has an explicit solution for this problem: a counter-contract with a value of -N30,000 is concluded between the mortgage department and the treasury. The simpler FTP system does not have a direct way of dealing with prepayments. Table 2 shows how these repayments are processed in both implementations.

1 In this example the costs of the interest rate dependency of prepayments are not explicitly calculated in advance.

2 is the solution of