Funds transfer pricing (FTP) has been an important tool for financial institutions for several decades. The methodology was introduced to banks in the early 1980s to help allocate corporate costs among business lines. Since then, the mechanism has been central to also helping allocate risk among business units. For instance, if your bank has interest rate sensitivity, what portion of the risk is driven by fee lines (f.e. mortgages), loans and deposits. In this article, we look at the concepts of FTP and detail how banks can use the methodology to better manage risk.
Over the years there has been a considerable debate at community banks on how to implement the principles of FTP to various balance sheet accounts like loans and deposits. Through the use of proper FTP data analysis and segmentation, community bank managers can realize considerable value in product pricing and incentive compensation programs. We would like to share a recent specific loan example demonstrating how FTP can help community bank price a commercial loan and design an effective incentive plan.
A key theme of FTP is to enable front-line business units to lay off interest rate risk in their loans and deposits to a central treasury function. This allows management to manage credit risk and operational risk across business units.
How FTP Works
FTP is both a regulatory requirement and an important tool for managing a firm’s balance sheet structure and measuring risk-adjusted profitability. FTP measures interest rate risk, liquidity risk, and enables cost to be transferred from central treasury functions to the bank’s products and business lines. Fundamentally, FTP divides a bank’s overall Net Interest Margin into two major sub-margins (one for deposits and one for asset origination). Banks can then measure the economic value obtained from each action taken separately.
However, FTP can then be extended to provide other analytical tools as shown in the graph below.
A few weeks ago we worked with a lender at a $3B community bank who was competing for a $3.2mm owner-occupied commercial loan. The lender was lamenting that on larger deals, with better credit quality, his pricing was not competitive. However, on smaller deals, and B and C credits, he could beat the market and win most deals. The reason for this phenomenon, the lender offered, was the bank’s cost of funding was high relative to the competition. Therefore, the bank could compete more effectively for higher-priced loans than for tighter priced loans. In our opinion, this is an example of a misconception of economics and the result of a lack of FTP implementation.
The lender ultimately lost the $3.2B owner-occupied real estate loan to a competitor but won a $600k investment property loan. The graph below outlines how the bank was looking at the $600k credit.
The bank’s cost of funding is currently 1.07%, and the $600k, five-year fixed rate loan is priced at 5.35%. Therefore, the bank’s margin is a healthy 4.28%. The lender will be compensated on this production and will continue to look aggressively for more credits like this one.
The graph below demonstrates the economics of the loan using an FTP framework.
The bank’s cost of funding today is 1.07% as the bank measures this cost. However, the bank is funding a five-year fixed rate, and the additional funding spread is 2.10% (the differential between the bank’s cost of deposits and five-year cost of funding). The bank is taking liquidity cost (the possibility that deposits prepay), and this contingent cost is an additional 15bps. The sum of these costs (1.07%, plus 2.10%, plus 0.15%) is the treasury cost of funding and is represented by the FTP horizontal line. On the loan side (everything above the FTP line) the bank is taking credit risk (ALLL), capital cost, and operational expenses. This leaves the loan side with an economic benefit (Net Margin) of 0.33%. This loan is profitable, but barely so. If any of the assumptions are off by 33bps – if the sum of credit cost, capital cost or operation expenses are 33bps higher – then the loan becomes a negative economic contribution for the bank.
We recommend that community banks incorporate a simple FTP model to allow appropriate product pricing and incentive compensation. The March 2016 Interagency Guidance on Funds Transfer Pricing outlines four principles related to funding and contingent liquidity risks as listed below:
- Principle 1: A firm should allocate FTP costs and benefits based on funding risk and contingent liquidity risk.
- Principle 2: A firm should have a consistent and transparent FTP framework for identifying and allocating FTP costs and benefits on a timely basis and at a sufficiently granular level, commensurate with the firm’s size, complexity, business activities, and overall risk profile.
- Principle 3: A firm should have a robust governance structure for FTP, including the production of a report on FTP and oversight from a senior management group and central management function.
- Principle 4: A firm should align business incentives with risk management and strategic objectives by incorporating FTP costs and benefits into product pricing, business metrics, and new product approval.
Principles 2 and 4 above are especially important and implementing an appropriate FTP framework will help community banks dissect net interest margin (NIM) in a manner the general ledger cannot. This allows community bank managers to do the following:
- Understand the profit contribution of its balance sheet products (loans versus deposits).
- Understand the profit contribution of a channel, an officer, an organization or individual customer.
- Create internal accountabilities and associated targets for funds users (credit risk takers) and funds providers (deposit gatherers).
- Price interest-earning products more knowledgeably based on risk-adjusted return on capital model.
- Reward loan officers, branch managers, and regional leaders based on margin contribution versus volume or revenue production.
Incorporating an FTP framework at community banks can radically change the understanding of the makeup of net interest margin and how the bank’s activities have contributed to economic profitability. Too often management focus and the incentive plans for commercial lenders are not properly aligned with the institution’s processes for measuring economic contribution. By using an appropriate FTP framework, a community bank can devise an incentive plan that rewards loan officers for the incremental NII revenue they generate after transfer pricing. Extending this approach to add economic capital to determine a risk-adjusted return on capital takes into consideration not only the volume and spread, but the underlying risk when calculating contribution and the associated incentive compensation plan.
Submitted by Chris Nichols on October 10, 2018