Funds Transfer Pricing: How to Measure Branch Profitability

Introduction:

Today's financial services industry is a highly competitive world. Banks are faced with competition from not single other financial institutions, but also, thrifts, insurance companies, investment companies, mortgage companies and others. Banks are facing immense challenges to achieve sustainable profitability. Historically depressed interest rates are compressing margins and forcing banks to enhance their performance management capabilities (Convery 2003)

One of the biggest measures of a bank's profitability is its toil interest income. Net interest income is by the agency of far the largest driver of returns profitability, typically accounting for up to 80 percent of a bank's income (Coffey, 2001).

Funds Transfer Pricing is an analysis tool that can be used to help a bank measure its profitability in a variety of different ways. It allows management to compare the profitability of different harvest lines within the company, and it can be drilled down plane further to allow comparison between individual employee It is also true useful for comparison between branches. This investigation will discuss the fundamentals of stock Transfer Pricing (FTP) and talk about in what manner Funds Transfer Pricing will affect the profitability of sum of two units branches of a bank.

Fund Transfer Pricing:

In simple boundarys transfer pricing is"A transfer price measures the value of outcomes furnished by a profit center to other responsibility center within a company. Internal exchanges that are measured by dint of transfer prices result in (1) receipts for the responsibility center furnishing (i.e. selling) the produce and (2) costs for the responsibility center receiving (i.e., buying) the product" (Anthony, 2004) In the banking industry, this would be deposits that are bring togethered by one branch and used by dint of another to fund loans. This proces is usually handled using an FTP combination of parts to form a whole

When a bank makes a loan to a customer, the funding for this loan has to draw near from one source or another. Typically, the funding in a financial institution will approach from deposits collected by the bank. This impressed sign of funding is normally the cheapest and greatest in quantity desirable; however, when deposits are not sufficient to capital all the needs for cash that the bank has, the bank will have to come by additional funding in the wholesale market. Therefore, each deposit brought in to the bank has a value to the financial institution for funding objects and, by the same token, a loan also has an underlying require to be paid [i]or[/i] undergone of funds and is not just interest income for the bank, as it would direct the eye in a typical income statement analysis. The object of FTP is to place a value upon each deposit and assign a require to be paid [i]or[/i] undergone to each loan that a bank has.

When implementing an FTP a whole banks' must determine a "funding curve" that greatest in quantity reflects their source or use of stocks on the wholesale market (Rice 2004) Many banks in the past used United States Treasuries as their funding 1 But recently, the government has dropp more [i]or[/i] less buckets from its information. Therefore, many banks have switched to the LIBOR/Swap bend The funding curve for a financial instrument displays the relationship between time to maturity and interest rate. Many banks make adjustments to these 1s to customize the curve to fit the banks unique lending environment. The liquidity premium shown in Exhibit 1 is similar an adjustment. This premium is added to the swap 1 rate to calculate the total FTP rate, which in this case would be 422 percent

Next each loan or deposit that the bank has is assigned a rate based on this adjusted funding curve. The rate that is assigned to these customer relationships will vary based on the characteristics of the relationship. individual characteristic that will cause a rate to change is time to maturity. For instance, a 5 year fixed rate note will be assigned a different rate than a 5year variable rate note. Also, for loans, the longer the terminus is to maturity, the higher the rate to stock that loan. For example, as shown by means of the yield curve in Exhibit 1 a fixed rate loan with a 5-year maturity would have a funding rate charge of 387 percent whereas, a fixed rate loan with a 10-year maturity would be somewhat higher below a normal funding curve. by the agency of the same principle, a deposit that has a longer maturity would be assigned a higher funding rate credit because the bank is guaranteed the use of these stocks for a longer period of time.

Looking at the 5-year fixed rate loan in Exhibit 1 it has a interest warrant rate of 6.00 percent and, based upon the adjusted Libor/Swap curve, it would be assigned an FTP rate that is 422; therefore, the FTP spread is 178 Or in other words, the rate the loan is bringing in to the bank is 178 percent higher than the funding rate would take away from the bank.

Other unique characteristics of a loan will cause the rate assigned to it to vary. individual such characteristic is a prepayment option upon a loan. As shown in Exhibit 2 a prepayment option will change the average wait fored life of the loan. This is an assumption that is based upon looking at historical trends in the bank. In this example, the average life of a 5-year fixed rate, prepayable loan with a interest warrant rate of 5.50 percent is determined to be 32 years. The Libor/Swap bend rate to fund this loan is 349 percent The liquidity premium is 25 percent and an option premium of 55 percent is added for the prepayment option to tend hitherward up with an FTP rate of 429 This would give an FTP spread of 121 percent