Transfer pricing is a process used in banking to measure the performance of different business units of a bank. Value placed on transfers within an organization, used as a means of allocating costs to various profit centers.
A bank could have different kinds of business units. Most important units are deposit-raising units and funds-advancing units. The former borrows funds from surplus units while the latter lends the same funds to deficit units. Both borrowing and lending contributes to the performance of the bank as a whole. Transfer Pricing is a mechanism to measure the relative contributions to the bank’s profitability and hence shareholder’s value.
An intermediary is created within the organization usually Treasury or Central Office. All the fund-raising units raise funds from the market at a particular rate and lend the same to the Central Office at a higher rate. All the lending units borrow the funds from the Central Office at a particular rate and lend the same to the borrowers at a higher rate. The Central Office rate is notional in nature and is aligned to market conditions. Thus, for all the units there are two rates available to measure the performance. For a deposit-raising unit the difference between interest paid to the deposit-holders and interest receivable from Central Office is the contribution to the bank’s profitability. For a lending division the difference between Interest payable to Central Office and the interest received from the borrowers is the contribution to the bank’s performance.