Funds Transfer Pricing
Principles for implemeting an FTP framework
The basic idea of transfer pricing in financial institutions is to allocate costs and benefi ts equitably across the bank. This enables the creation of (isolated) internal P&Ls for diff erent departments. Hence, funds transfer pricing (FTP) helps management to measure performance and to focus on profi table markets and clients. FTP is also often the basis for performance-based remuneration. However, to draw the right conclusions certain principles should be applied when implementing an FTP framework.
At first glance, FTP only measures performance in diff erent areas of the bank. For instance, it can identify profi ts – by off setting all risks hypothetically – from a particular client or a client group, on specifi c types of products, or a particular branch. This information is valuable for management and client advisors as it allows conclusions about the performance of a certain division and what measures should be implemented to improve profi tability. Beyond that, it can also be used to value a branch that might be sold.
In addition, FTP is usually the basis for performance-based remuneration. Therefore, it is important that the FTP framework sets the right incentives for employees to achieve the bank’s strategic objectives.
But FTP is more than a management tool providing insights about a bank’s cost structure and the performance or contribution of diff erent divisions. It can also be used as a forward-looking tool, as it allows management to identify growth potential and find measures to improve profi tability. Hence, FTP provides valuable information to defi ne and implement a bank’s strategy and to enhance a bank’s competitiveness.
However, the financial crisis has revealed that the FTP set-up can have a strong and even a negative infl uence on the employees’ behavior. For instance, liquidity costs and contingency costs were and still are rarely allocated properly. If liquidity spreads are ignored, traders might enter transactions that imply a positive performance but which in fact, when considering the liquidity spreads, would be negative. Hence, in this example the bank encourages traders to accumulate unprofi table positions and even worse, might pay a bonus based on them. The use of historical cost is another example that leads to an inappropriate FTP framework. When rates rise, using average historical costs understates the actual cost of funding and hence will not cover actual costs and meet profi t targets. When rates fall, average historical costs overstate actual interest costs and pricing is no longer competitive.
Furthermore, some banks use accounting P&L, i.e., periodic P&L, to calculate an advisor’s performance. However, as this type of P&L also includes loan transactions entered some years ago, the actual year-to-date performance is not transparent. Hence, an advisor benefi ts or suff ers from the performance of his or her predecessor. Only the focus on economic value of new business allows an appropriate performance measurement. The frequency of FTP calculations also matters. Banks that measure the P&L only on a weekly basis eff ectively ignore every transaction traded between the two measurement periods for allocating financing costs. Consequently, the performance is overestimated due to the lack of cost allocation.
Having observed such shortcomings leading to wrong incentives and potentially threatening a bank’s going concern, FTP is on the radar of regulators: the European Banking Authority (EBA) published the ‘Guidelines on Liquidity Cost Benefit Allocation’ in 2010 and local regulators such as the FSA or the BaFin have formally embedded FTP requirements into their standards. Although the standards could be the starting point to benchmark a bank’s FTP framework, the requirements are very general and lack specifi cation, in particular with respect to methodology.
Besides a sustainable and thought-through methodology, the FTP needs to satisfy certain additional principles to make it the powerful management tool it can be. In addition to the regulatory requirements, we identify 10 important principles based on our practical implementation experience indicated above. These principles are briefl y summarized below.
These principles are based on practical experience. They prevent setting the wrong incentives as illustrated at the beginning and, as such, they support achieving the bank’s long-term profi tability targets. In addition, these principles go beyond the regulatory requirements by specifying the set-up and methodology that should be used. Therefore, the principles can be used as an additional benchmark of an existing FTP framework or could be used to re-design it. Anyhow, they will further improve transparency of performance and enable management to derive the right measures to improve profi tability in the long run.
10 principles for implementing a funds transfer pricing framework
- Segregation of responsibilities
The FTP framework should allocate costs, risks, and benefi ts in line with the relevant responsibilities. For example, it should separate the treasury’s performance from the performance of the sales department. Treasury is responsible for taking and hedging (financial) risks and sales is responsible for contracting. Hence, sales should transfer all major financial risks to treasury.
- Completeness of products
The FTP framework should cover all entered transactions, i.e., all assets, liabilities and off -balance-sheet items including contingent liabilities. It should also consider all divisions of the bank.
- Level of granularity
Costs and benefi ts should be allocated on a single transaction level. This allows generating quasi-P&Ls on all conceivable levels of the bank (e.g., on a single client, per client advisor or branch, per country, or for a whole division).
- Update mechanism
Due to system restrictions, some banks allocate costs only on month-end positions. This allows traders to open and close positions between the measuring dates without being charged for costs. To avoid such arbitrage opportunities, benefi ts and costs should be allocated daily.
- Pre- and post-calculation of products
The FTP process should diff erentiate between pre- and post calculation. Pre-calculation should for example ensure that sales and trading are informed about actual costs before entering a deal. By knowing the standard net margins beforehand, sales is able to profi tably negotiate margins with clients.
- Type of costs
The allocation mechanism should be holistic: it should consider all types of direct and indirect costs. This includes the interest rate (incl. optionalities) and liquidity part as well as the credit risk component (expected and unexpected loss), but also any standard unit costs.
- Marginal costs and maturity matching
Some banks still use (historical) eff ective interest and funding costs. As this could result in wrong incentives and over- or underestimate actual performance, marginal costs should be used. Furthermore, the interest and funding costs should be diff erentiated with respect to maturity.
- Periodic vs. economic value perspective
The periodic perspective focuses on the accounting P&L, whereas the economic value perspective calculates the NPV of the margins. Since the economic value perspective measures the product’s success over its whole lifetime, it should be used for FTP purposes.
- Reporting, communication and transparency
To ensure the acceptance of the FTP framework within the bank, processes and methodology should be properly documented, reporting should be self-explanatory and all stakeholders should be coached regularly. Only transparency will ensure that the FTP framework can be understood and will be accepted by the diff erent profi t centers.
- Regular review
As the (banking) environment changes over time, the FTP framework and the behavior it triggers should be reviewed regularly. Moreover, FTP should be embedded into the organization and decision-making processes, including in new product approval process and sales training.