Worldwide, banks operate in a highly complex and competitive landscape. There are many ways to measure and report business performance. Some of the traditional metrics such as ROA, ROE, NIM, etc. provide a fair assessment of the bank at a macro level. A common metric traditionally used to measure performance has been Net Income. But they fail to measure performance at granular levels (branch, area, officer, etc.) without incorporating an FTP (Fund Transfer Pricing) system, which is also known as Transfer Pricing Mechanism (TPM).
A commercial bank typically has two divisions: Lending and Deposit. The deposit division acquires funds from customers in the form of deposit that are then passed on to the Treasury division for proper deployment. These funds are passed on to the Lending division for lending to customers as loans. In case of shortage of funds from Deposits for loans, Treasury procures additional funds from the wholesale market. The interest earned on loans constitutes Interest Income; the interest paid on Deposits is called Interest Expense and the difference between the two is called Net Interest Income (which is generally reported on the income statement).
By merely ascertaining the Net Interest Income equation from the income statement it would seem as though all loans are profitable and all deposits cause loss. Each deposit has its own value as a source for loans and similarly each loan has its own cost of funding.
The purpose of FTP is to measure individually how each source of funding contributes to the overall profitability of the bank. FTP is a process used in banks 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. Internal bank funds pricing is a key element in bank liquidity risk management. An inappropriate or artificial internal funds pricing policy can result in poor business decision-making as well as generate excessive exposure to liquidity and funding risk.
Transfer prices tend not to differ much from the price in the market because one of the entities in such a transaction will lose out: they will either be buying for more than the prevailing market price or selling below the market price, and this will affect their performance. Main objective of FTP is the evaluation of true profit and operational efficiency of bank branches. This also ensures equitable distribution of profit. These components work together to accomplish the overall objective of keeping the funding stream from head office to bank branch as stable as possible. A bank can use the inter-branch balance as the amount lent or borrowed by the branch for transfer pricing, because that is the funds transferred to sister branches via Head Office/ Regional Office or borrowed from sister branches via Head Office/Regional Office.
FTP is profit neutral. It will not have any impact of the bank’s profitability. The total debit at Head Office will be offset by the credits at the branches and vice versa.
- The unitary system is the simplest because there’s only one rate for lending and borrowing from the head office. It doesn’t matter whether bank balances are based on credit or debit.
- The dual system uses one rate for borrowing and another for lending by the head office.
- Multiple systems implement multiple price mechanisms. Deposits and advances are provided by the head office at different rates – although branch profitability is based on both, instead of stressing one or the other.
The unitary system has two flaws. Bank branches supported by advances reflect higher profits than those supported by deposits. This happens because deposits garner more interest payments than advances. Additionally, the unitary system fails to identify the performance between fund allocation and its performance.
The dual system doesn’t take into consideration interest rate structures determined, not by the head office but the market itself. Advance-based branches are inaccurately represented because there is no differentiation between types of advances bundled together. Term deposit-based branches indicate lower profits because the interest rate is high.
Multiple systems are prone to problems related to international banking practices. Although the cost of running each branch differs from branch to branch and changes year to year, this is not reflected in profitability reports until the cost is stabilized. Overall, there are no set rules regarding profitability, so there is vulnerability to any change in business operations.
A good FTP system can enhance the decision making capabilities of the bank across resource allocation, cost control and budgeting and planning to raise profitability levels. FTP is important in the risk management process essentially because — as it is the price at which an individual business line raises funds from its own treasury desk — it is a key parameter in business decision-making. For all banks it is imperative to operate a robust and disciplined internal funding mechanism, and one that is integrated into the overall liquidity risk management framework.