Funds Transfer Pricing and Risk Adjusted Performance Measurement
Posted: 31 May 2012 Last revised: 27 Mar 2013
Date Written: May 30, 2010
Funds transfer pricing has been used by banks for many decades. Today, it is a central component in banks for:
• Achieving centralization of risks – i.e., clear branch risks (such as interest rate risk) that are most efficiently managed centrally.
• Measuring ex-ante performance of traditional banking book items, such as loans, mortgages and deposits.
A loan or deposit clearing of interest rate risk is achieved through the funds transfer price, defined as the matched maturity funding rate plus a mark-up for business costs. In effect, this is an interest rate swap agreement between the loan branch and the clearing center, and the price of the swap is usually null. For ex-ante performance evaluation of branches, the assigned funds transfer rate is used to measure a net interest margin vs. the transfer rate. The difference between the transfer rate and the actual funding is managed on residual terms by Treasury. This assignment of a matching funding asset or liability to a corresponding branch liability or asset also achieves balanced balance sheets for branches; therefore, each branch becomes a consistent performance measurement unit.
In practice, risks other than interest rate risk, such as credit and operational risks, are also part of the transfer pricing. For example, clearing branch credit risk that is the size of the risk spread added to the funds transfer price should be related to the cost of clearing the risk. While such risk spreads may be available for traded assets, the risk spread for nontraded, traditional balance sheet items has to be defined internally. The clearing of credit risk from branches and centralization to Treasury may seem a natural step as the efficient hedging of credit risk requires a portfolio perspective. However, there are also drawbacks to clearing branches’ credit risks. Most notably, the clearing of the credit risk Essentially removes the branch incentive to actually manage the credit issued locally by the branch.
Another complex issue in funds transfer pricing is how to measure funds transfer prices when future cash flows are uncertain. This is the case for most deposits where consumers can withdraw their funds at any point in time, and hence the branch has in effect issued a withdrawal option on the account. Other examples include loans with prepayment and associated caps and floors. Since the funds transfer rate should represent the actual cost of matched maturity funds, a bank cannot ignore incorporating the additional cost for embedded options in branch products. If they do, then incentives to issue embedded products that raise the interest rate paid by consumers, such as floors and embedded call options, increase.
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