Fund Travel Pricing

PURPOSE

Funds transfer pricing is an internal measurement and allocation process that assigns a profit contribution value to funds gathered and lent or invested by the bank. It is a critical component of the profitability measurement process, as it allocates the major contributor to profitability, net interest margin.

BACKGROUND

Financial institutions act as intermediaries of deposit and loanable funds. The institution's business units routinely receive funds from their depositing customers and other third parties. These funds are subsequently invested in loans and investments, sometimes through different business units, to borrowing customers and other third parties.

Financial agreements between the financial institution and its customers described the amount, term and interest rate of funds collected and invested. The interest payments on these funds contribute to the institution's overall net interest margin.

The institution's net interest margin is the difference between interest revenue earned on funds used to acquire assets less the interest expense on funds gathered. The institution's net interest margin, and the value of its financial contracts fluctuate as market conditions and the underlying cash flow of the funds change over time.

Business units and customers participate in the continuous funds intermediation process that creates the net interest margin. However, the contribution to the net margin and value is not equal by all participants. Business units and customers rarely provide the same amount of funds as they use. The discrete contribution of funds transformed within the intermediation process must be measured and assigned when assessing their overall profit contribution of business units, products and customers. This is the function of a funds transfer pricing process.

COMMON FTP METHODOLOGIES

Numerous transfer-pricing methods have been advanced in order to address the issue of identifying the net margin and value contribution of funds gathered and used. Most of the suggested methods fall into one of two major categories: pooled approaches or specific assignment approaches. Under either of these two general approaches, a transfer rate is assigned to the funds provided or used. The transfer rate provides the basis for the allocation of contribution to the institution's overall margin.

Under pooled approaches, funds are assigned to one or more pools created under a pre-defined set of criteria. Criteria for pool classification may be based on type, term, repricing term, origination, or other fund attributes. The transfer rate assigned to individual pools is derived either internally, based on actual rates earned or paid, or alternatively, by market-derived interest rates.

Single pool - Single Rate method's choice of transfer rate biases contribution measurement results. Under the single pool method, a transfer rate based on the cost of funds favors net fund user's contribution. Transfer rates based on asset yields favors net funds provider's contribution.

The shortcoming of a single pool FTP mechanism is that it assumes all funds have equal importance to the financial institution. Because a single rate applies to funds equally, the method does not differentiate value based on the attributes of the funds provided or used, nor market conditions at the time of transaction origination.

Multiple Pools - Multiple transfer rates methods go beyond simple pool methods by including fund attributes, primarily their maturity, when assigning a contribution value to funds. Under this approach, numerous pools are created, each spanning a unique segment of the maturity spectrum. The assigned transfer rate of each pool is based on its maturity and prevailing interest rates. Long maturity pools receive a long-term rate, while short-term pools receive a transfer rate reflective of their shorter tenor. Other unique fund attributes may also be considered when assigning a contribution value.

The number and nature of the pools created should reflect the major maturity aspects of the balance sheet, which varies by institution. Each pool's transfer rate is representative of the prevailing market rate for its term. Because the transfer rates are based on market rates, the determination of contribution value reflects the competitive nature of the financial intermediation process. Funds provided at rates below the prevailing market rates are accorded greater contribution value. Funds employed at rates above the prevailing market are accorded greater contribution value.

When determining the ongoing source of transfer rates used in multiple pool approaches, two alternatives are available. The first alternative is to use contemporary market rates, while the second alternative is to use market rates prevailing at the time of transaction origination.

Multiple pool approaches that use contemporary market rates lack the ability to benchmark management decisions made at the time of initial transaction pricing. To evaluate pricing decisions for transactions originating in prior periods, the contribution value must be benchmarked against the prevailing rates at time of origination. To address this condition, a variation of the multiple pool method creates a series of pools of a historical nature.