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Best Practices & Strategic Value of Funds

Transfer Pricing
Journal of Performance Management, 2009 by Hanselman,
Orlando B
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Executive Summary: Do you know where your profits come from? Do you know which products
or customers create value for the financial institution ("FSI") and which destroy it? Sadly, most
FSI today do not have the measured answers to these questions. And too often the intuitive
answers are at best misleading or frequently wrong. Currently most FSI simply price loans and
deposits to mimic their competitors, who generally have different strategies, goals, risk
tolerances and cost structures. Increasingly, however, high performance FSI wishing to create a
winning competitive advantage use matched-term funds transfer pricing ("FTP"). These high
performance financial institutions use FTP'S insights to create strategic value and optimize net
interest margins. This article discusses the basics of matched-term funds transfer pricing. Current
FTP best practices used by FSI world-wide, introductory insights into FTP'S strategic value and
tips for getting started are also covered.

More Articles of Interest

• To FTP Or Not To FTP - That Is The Question!*

• Beyond Funds Transfer Pricing to Actionable Decision-Making
• Transfer Pricing Capital*
• FUNDS TRANSFER PRICING
• Transfer Pricing Indeterminate-Maturity Deposits

Financial institutions ("FSI") eagerly seeking a competitive advantage understand and pursue the
substantial strategic benefits derived from best practice matched-term funds transfer pricing
("FTP") at the instrument level. Matched -term FTP is widely embraced by high performing FSI
that recognize it as a critical path to enlightened risk and return net interest margin analytics as
well as key to optimize margin performance. These high performance FSI comprehend the truth
that you cannot effectively manage without measured insights.

Roles and Strategic Benefits

Funds transfer pricing is an internal management information system and methodology designed
to allocate the net interest margin between funds users, such as lenders and investment officers,
and funds providers, including branch deposit gathers and the treasury function. Equally true and
more pragmatic is the definition of FTP as a rigorous measurement and pricing method based
upon the pretense that all funds are bought and sold in an open market. Best practices matched-
term FTP establishes a framework for this net interest margin allocation process by incorporating
this market pretense concept.

Since FTP fosters improved understanding and valuable strategic insights related to the single
largest contributor of a FSI's financial performance, the net interest margin, its importance
cannot be over emphasized. Increasingly FSI executives acknowledge FTP as the most essential
component of a well developed and comprehensive profitability measurement system. Matched-
term FTP is the only path to measuring, understanding and effectively managing customer
profitability. Simply put, a FSI cannot measure customer profitability without a sound and
proven net interest margin allocation methodology as provided by instrument level matched-term
FTP.

A best practice FTP system is both a risk and return analytical tool. With a well designed FTP
system, a FSI will be able to:

* Measure business unit, product and customer profitability.

* Measure and segregate net interest margin risk components.

* Achieve improved net interest margin accountability and segregation of duties.

* Develop a sound basis for optimal customized loan and deposit pricing.

* Institute improved risk-based product pricing with higher net interest spreads.

Highly successful executives have always understood the fundamental management truths that
you cannot manage something if you do not measure it and if everyone is accountable for an
important performance factor no one is accountable. Matched-term FTP adheres to these
fundamental management truths.

The Basics

Financial instrument by financial instrument, each source of funds, such as a deposit or

borrowing, and each use of funds, such as a loan or investment, are valued at the time of their
origination. This valuation is accomplished by assigning each financial instrument an associated
transfer rate from an appropriate transfer curve(s). The associated transfer rate mirrors as closely
as possible the underlying financial instrument's cash flows, repricing and optionality attributes.
This assigned transfer rate is then wed to the financial instrument and does not change until the
financial instrument either matures or reprices. The allocation of the FSI's net interest margin is
accomplished by this instrument by instrument valuation. With this instrument level processing,
the FSI effectively aggregates FTP results at the total organizational level as well as at the
business unit, product and customer levels.

Assigned transfer rates must match the financial instrument as closely as possible. Cash flow,
repricing and maturity of the instrument will be used to determine the appropriate point on the
transfer curve(s) to find the transfer rate. While indeterminate maturity financial instruments
such as credit cards, open lines of credit and checking accounts pose an additional challenge,
several best practice methods for effectively estimating their maturity have emerged and become
well accepted within the industry. If the underlying financial instrument has a fixed rate, the
transfer rate should be a fixed rate. Adjustable rate financial instruments should have a transfer
rate which changes upon the instrument's reset date. Floating rate instruments should have a
floating transfer rate. Financial instruments that amortize should have a transfer rate that
considers amortization. And finally, if the underlying financial instrument allows for
prepayments or early withdrawals, the transfer rate should do the same.

1In selecting transfer curve(s) some FSI use one curve for all assets and liabilities, while others
prefer multiple curves dependent upon the specific nature of their different assets and liabilities.
FSI opting for one curve for the entire balance sheet generally assess their tendency to be either
asset or liability heavy and select the curve to correspond to their positioning. Using more than
one curve may introduce an element of basis risk due to the possibility of fluctuations in the
spread between either the asset or the liability transfer curves. This concern is largely mitigated
since the process of matched-term FTP effectively isolates interest rate risk, including such
created basis risk, to the centralized funding center. It is the funding center which earns a
mismatch spread as a return for responsible management of the FSI's aggregate interest rate risk.
Acceptable market-driven curve choices include those associated with government investments
and bonds, LIBOR, advance borrowings offered by governments and their agencies, SWAPS,
commercial paper and brokered deposits. Some FSI even construct a curve based upon a
combination of these choices such as use of an overnight government rate at the shortest end,
commercial paper for the intermediate term and government advances for the long-term.

More Articles of Interest

• To FTP Or Not To FTP - That Is The Question!*

• Beyond Funds Transfer Pricing to Actionable Decision-Making
• Transfer Pricing Capital*
• FUNDS TRANSFER PRICING
• Transfer Pricing Indeterminate-Maturity Deposits

No one "right" answer has yet emerged as best practice in choosing a FSI's fund transfer pricing
curve(s). Each option presented has both strengths and weaknesses. Intelligent selection of funds
transfer price curve(s) must, however, encompass our agreed-upon FTP market pretense
definition as well as embrace certain critical characteristics related to optimal curve(s) choice.
Four critical curve(s) characteristics are generally accepted:

1 . Curve(s) should represent the opportunity cost or benefit of the funds.

2. Curve(s) should represent marginal wholesale rates.

3. Curve(s) should be derived from reliable and readily available data sources.

4. Curve(s) should be credible as well as understood by and acceptable to FTP users such as
lenders, investment officers, liquidity managers, branch deposit gatherers and treasury personnel.

Many FSI, based upon this conceptually sound thought process, utilize two curves best tailored
to their unique business model of incremental funds deployment and procurement: a market-
based alternative investment curve for deposits and borrowings and a market-based alternative
liquidity funding source curve for loans and investments. This curve decision is sound in
definition and characteristics, practical and realistic in design and allows simple execution for the
entire balance sheet.

To ensure the transfer rate best mirrors the cash flow of the underlying financial instrument, FSI
generally use a strip funded methodology (FIGURE 1). Each principal cash flow, unadjusted for
prepayment or early withdrawal, is valued separately on the transfer curve to arrive at a blended
transfer rate. For example, a six year $20,000 amortizing loan with an 8.0% interest rate would
be wed to a blended transfer rate of 4.9%, representing a composite of six different points on the
transfer curve at loan origination, each point reflecting the annual principal repayment cash
flows. Using this strip funded methodology provides a better matched transfer rate more closely
mirroring the financial instrument's cash flows, giving full consideration of the yield curve shape
of the market-based transfer curve. Accordingly, the strip funded methodology best captures both
the cash flow as well as the economic market reality at loan origination.

The matched-term FTP method is performed financial instrument by financial instrument at the
time of the instrument's origination. The net interest margin is allocated by assigning notional
transfer rates to all fund sources and uses. This process determines transfer expense related to
assets such as loans or investments and transfer income related to funding liabilities such as
deposits and borrowings. Only through this process is the well understood and accepted
economic value of customer deposits and FSI branches measured and recognized.

More Articles of Interest

• To FTP Or Not To FTP - That Is The Question!*

• Beyond Funds Transfer Pricing to Actionable Decision-Making
• Transfer Pricing Capital*
• FUNDS TRANSFER PRICING
• Transfer Pricing Indeterminate-Maturity Deposits
Generally speaking, when a loan is originated the transfer rate is established by locating on the
selected transfer curve the corresponding term point, or points in the case of the recommended
strip funded approach. This matched transfer rate or blended transfer rate derived from the curve
is then wed to the underlying financial instrument. Our FIGURE 2 example shows a one year
loan with a rate charged to the customer of 7.25% wed to a 5.25% transfer expense rate,
representing the market-based incremental funding cost. This 2.00% difference between the rate
negotiated with and paid by the borrower and the transfer rate is the credit spread. Credit spread
is earned by the lenders for assuming credit risk and it must be adequate to compensate for:
credit losses; direct operating costs related to the lending operations and loan servicing; and
general allocated FSI overhead. This net credit spread must also generate an adequate
profitability return.

Likewise, for a deposit account the appropriate point on the selected transfer curve is located to
match the underlying financial instrument. Our FIGURE 2 example shows a 3 month 3.25%
customer certificate of deposit matched to a transfer income rate of 4.25%, representing the
market-based incremental value of the funds provided. This 1.00% difference between the
transfer income rate and the deposit rate paid to the customer is known as the deposit franchise
spread. The deposit franchise spread is earned by the branch for cost effectively obtaining retail
funding for the FSI. This deposit franchise spread must be adequate to compensate for direct
operating costs of the branch and retail delivery systems as well as general allocated credit FSI
overhead. This net deposit spread must also generate an adequate profitability return.

After every financial instrument has been valued one by one through the FTP system, the
remaining difference between all transfer rates is known as the mismatch spread. Our FIGURE 2
example shows a mismatch spread of 1.00%. This mismatch spread is earned by the FSI's
funding center. It is the funding center, created as a business unit during implementation of the
FTP process, which manages holistically the aggregate interest rate and market risk of the FSI.
The mismatch spread compensates the funding center for assuming responsibility for mismatch
risk management and must be adequate to cover: direct operating costs of the funding center;
general allocated FSI overhead; and hedging or other costs of mismatch risk protection. It must
also produce an adequate profitability return.

Some FSI elect to make other adjustments to the derived transfer rates including:

* early withdrawal penalties, reserve requirements and insurance premiums for deposits.

* prepayment penalties, collateral costs and liquidity premiums for loans.

Using special product promotions, FSI more effectively reach growth and balance goals by
adjusting derived transfer rates to further incent desired business unit and employee behaviors.
The FSI's need to rebalance risk exposures, such as lending concentrations, may also be
facilitated by temporary transfer rate adjustments. FSI choose to make these elective adjustments
based upon their unique strategies, goals and risk tolerances as well as the materiality to the net
interest margin of the factors being considered.

More Articles of Interest

 • To FTP Or Not To FTP - That Is The Question!*
• Beyond Funds Transfer Pricing to Actionable Decision-Making
• Transfer Pricing Capital*
• FUNDS TRANSFER PRICING
• Transfer Pricing Indeterminate-Maturity Deposits

It is in this manner, financial instrument by financial instrument, that matched-term FTP

allocates the net interest margin contribution and establishes improved net interest margin
accountability. While every FSI measures and reports their total net interest margin, only those
using FTP are able to explain and quantify these three sources of net interest margin
contribution: credit spread; deposit franchise spread; and mismatch spread. Improved margin
accountability is achieved because we now have three discrete management buckets, each
containing segregated risk, return and responsibility. The lender bucket holds assumed credit risk
with resulting credit spread return and establishes exclusive lender accountability for managing
the FSI's credit risk. The branch bucket holds assumed liquidity risk with the resulting deposit
franchise spread return and establishes exclusive branch responsibility for cost effectively
obtaining the appropriate amounts of retail funding just in time as needed. And finally, the
funding center bucket holds assumed interest and market risk with the resulting mismatch spread
return and establishes exclusive responsibility for macro-management of the FSI's interest and
market risk. These three buckets provide the FSI with heightened accountability and enhanced
segregation of duties.

As a result of this process, the FSI has now achieved the first critical step in measuring its
business unit, product and customer profitability, an allocated net interest margin. Bear in mind,
without FTP, a typical branch's income statement is primarily comprised of fee income, deposit
expense, overhead expenses and some direct loan income. The major source of a branch's
economic contribution to the FSI, which is only measured with FTP, is the deposit franchise
spread earned on its generated deposits. Likewise, a lending unit's income statement without FTP
is primarily comprised of loan income, credit losses and overhead. Without FTP lending units are
not assessed a cost of funding for the loans they make, much akin to selling cars without paying
for the steel used in manufacturing. It is only through use of an FTP system that business unit
profitability can be properly measured and thereafter appropriately managed. Once each financial
instrument has an associated transfer cost or value, product and customer profitability becomes
the aggregation of all allocated net interest margin dollars associated with the applicable
underlying instruments

Sound Starting Point for Pricing

Each FSI may now use these well grounded FTP insights to provide optimal customized loan and
deposit pricing. Such optimal pricing begins with the FTP derived cost of funds used or value of
funds provided plus consideration ofthe following elements:

* Costs of business operations.

* Goals and strategies.

* Imbedded transaction risks.

These elements are specific to each FSI and should not be ignored when establishing prices.

Our optimal customized loan price would be determined by this formula:

FTP cost of funds used

Fixed and variable lifetime costs associated with the loan

More Articles of Interest

• To FTP Or Not To FTP - That Is The Question!*

• Beyond Funds Transfer Pricing to Actionable Decision-Making
• Transfer Pricing Capital*
• FUNDS TRANSFER PRICING
• Transfer Pricing Indeterminate-Maturity Deposits

Cost of assigned capital based upon all imbedded risks (credit, interest rate, market, liquidity and
operational) related to the loan as well as specific to the customer

Strategic return expected

For deposits, the formula for optimal customized pricing would be:

FTP value of funds provided

- Fixed and variable lifetime costs associated with the deposit

- Cost of assigned capital based upon all imbedded risks (interest rate, market, liquidity and
operational) related to the deposit

- Strategic return expected

These FTP based formulae determine a FSI's unique and optimal price which provides an
economic risk-adjusted profit as well as book profit at the strategic return rate expected. From
this suggested optimal price, further tailored pricing refinements may be considered such as the
customer's loyalty and price elasticity as well as specific valueadded product features. The local
competitive market as well as the FSI's balance sheet needs and risk positioning must also be
considered prior to finalizing the price.

Getting Started

Some FSI have failed to pursue the significant strategic value offered by FTP because of their
lack of knowledge, concerns related to cost and time involved and a mistaken belief that their
current measurements are adequate. Shrinking industry net interest margins are accenting the
need for FTP. Falling PC-based FTP technology costs are expanding the affordability and
scalability of this proven solution. These market factors, coupled with high performing FSI's
demonstrated FTP success and heightened regulatory demand for better risk-based pricing,
resoundingly rebut the rationality of this inaction. Reasonable implementation time is required,
however, and like any worthwhile journey it begins with the first step. Four key steps guide this
profitable strategic journey:

1. Educate and involve key FSI personnel. While the Chief Financial Officer and the accounting
staff are most likely going to lead this journey, it is critical to ultimate success that executive
officers and lenders as well as branch, investment, treasury and marketing personnel be actively
involved and that they collectively reach a level of comfort and understanding. The return on
your FTP investment comes from optimizing the net interest margin with enhanced
accountability and pricing sophistication based upon daily effective use and understanding by
lenders and branch, treasury and investment personnel.

2. Form a project steering committee including finance and accounting staff as well as key end
users. The steering committee is essential to ensure FTP understanding and acceptance, adept
project management, involvement, thorough communication and timely implementation. The
appointed committee chair should be knowledgeable, respected and unbiased. It is the chair who
must freely facilitate discussion to reach accepted consensus on FTP'S many choices and
assumptions. When consensus cannot be reached in a reasonable timeframe, however, the chair
must have the authority and grit to end further fruitless discussion and pronounce a binding
decision.

More Articles of Interest

• To FTP Or Not To FTP - That Is The Question!*

• Beyond Funds Transfer Pricing to Actionable Decision-Making
• Transfer Pricing Capital*
• FUNDS TRANSFER PRICING
• Transfer Pricing Indeterminate-Maturity Deposits

3. Review vendor FTP systems and PC-based models. Your steering committee should select a
vendor who provides you with a robust and flexible tool and, most critically, exceptional
implementation and postimplementation technical support. The software model should
accommodate a vast variety of rate adjustments as well as complex financial instrument cash
flows. Ideally your FTP model should also promote integrated data and insight sharing between
your other profitability measurement, budgeting, risk analytics and performance management
software. Vendors must also possess a strong client base and a history of long-term financial
industry software leadership. Independent and leading edge education aimed at understanding
and utilizing system reports, incorporating data insights into sound winning strategy, and earning
an acceptable return on your software investment ("ROI") is mission critical. Avoid vendors who
do not offer this education.
4. Collaborate with your chosen vendor to:

a. Decide on the rationale and source of transfer curve(s)

b. Gather data and implement a customized FTP system tailored to your strategies, philosophies
and goals.

c. Produce, analyze and adjust preliminary results. Remember that this will be an evolutionary
process of continuous improvement and refinement. Initial reports will require refinements and
adjustments.

An educated and involved steering committee is essential for success of the project and
realization of the ROI. The steering committee should be involved from the very outset until
credible reports are being consistently produced and used by line personnel. It is the
responsibility of the steering committee to ensure that personnel understand and participate in
system design to ensure buy-in. The steering committee must also keep the project progressing,
avoiding a costly search for elusive and unnecessary "precision". The goal is to produce a fair
and realistic assessment of the net interest margin contribution as well as credible results for
users. Finally, the steering committee must actively employ education and communication to
overcome imbedded cultural barriers. Overcoming such barriers is essential to embracing FTP
and unlocking its strategic value and ROI.

Conclusion

The world-wide consensus is that best practice FTP requires assignment of a marketbased
contribution value to funds provided and used determined by assessment of each individual
financial instrument at the time of origination. It is also essential that your FTP system is
understandable, explainable, consistent, well documented and credible with users. Your FTP
system must be customized to your unique FSI. High performance FSI wishing to create a
winning competitive advantage use FTP's insights to create strategic value and optimize net
interest margins. They recognize that FTP is a critical path to enlightened risk and return net
interest margin analytics and is key to optimizing the margin. Begin your profitable journey on
this proven path today