TRANSFER FUNDING (FTP)
A TOOL FOR ASSET LIABILITY MANAGEMENT (ALM)
By Sriram Gade, The Head of Credit at First Merchant Bank

Growth in business volumes does not automatically mean growth in profits. Competition and deregulation cause thinner margins which affect the profitability. Higher profit along with growth in assets and liabilities is the key to survival and success of a corporate. Consequently, profit management has become the main focus in modern times. For a corporate with multiple products, several operating units and numerous customers, determination of product-wise, operating unit-wise, customer-wise profitability enables better profit planning through identification of high profit segments, products, customers etc. Especially, for banks having multiple products, customers, branches, segments etc., calculating economic contribution of each of these classes could assist in strategic planning for profit growth.

Though banks know their aggregate interest income and interest expenses, their boards need to know the contribution of an account or group of accounts to the net interest income (NII) and eventually to bottom line. Ability to calculate class-wise profits enables a bank to identify growth areas and unprofitable segments. When growth areas are strengthened and unprofitable areas are controlled, the profit grows. World over NII accounts for 60-80% of income of a bank and the management must know the sources which truly contribute to NII.

One of the methods employed internationally in this regard is funds transfer pricing (FTP) which is more relevant for financial institutions and banks as they deal mainly in funds. Internal business units of an institution raise funds through deposits and utilize funds for assets like loans and investments. FTP primarily envisages determining the internal rates offered on funds raised and funds utilized. It is assumed that the business units borrow or invest funds through an apex unit normally called Central Funding Unit (CFU) which is parked in the Finance Department of the institution.

The main methods of FTP those are used internationally are single pool, multiple pool and matched funds methods. Under single pool method all the funds are assumed to be under a single pool. Borrowing units draw funds from the pool and providers of funds supply to the pool. There is a single rate for both providers and users of funds. The rate used for transfer pricing could be a short-term rate like federal funds rate in the US or a rate between average cost of deposits and average return on assets. While single pool system is simple to understand and easy to implement, it is less scientific than the other methods.

Multiple pool method assumes existence of at least two pools; one for users of funds and the other for providers of funds. Additional pools could be assumed based on the repricing features of assets and liabilities. The difference between the rate offered on liabilities and the rate charged for assets represents spread for the CFU. The rate offered on deposits is higher than the average cost of deposits adjusted for factors like liquidity reserve while the rate offered for assets will be lower than the average return on assets. Multiple pool method is more scientific than single pool method.

Both single pool and multiple methods can be implemented in either gross or net basis. Under gross basis, the assets and liabilities are transfer priced separately while under net basis the business units are transfer priced based on their net positions in assets and liabilities. For instance if a business unit has MK 100 million in loans and MK 50 million in deposits, it will be transfer priced for borrowing MK 50 million from CFU under net basis. Under gross basis, it will be transfer priced separately for borrowing MK 100 million from CFU and investing MK 50 million with CFU.

The third method of FTP, the most scientific and sophisticated one, is matched funds pricing (MFP). MFP is being increasingly adopted by more and more professional banks world wide and hence the method needs discussion in greater detail.

MFP assumes that each asset and liability has a matching item on the other side of balance sheet. An asset is assumed to have been funded by a matching liability and a liability is assumed to have been invested in a matching asset. Matching implies the similarity of repricing characteristics. The transfer price rates are market related implying that CFU lends and borrows funds at market rates.

For example, if a branch raises a deposit for two months, CFU takes it at a rate of two months’ money market rate prevailing at the date of raising the deposit. Similarly, if an operating unit lends funds by way of an overdraft for one year, CFU lends funds to the operating unit at one year money market rate. As the assets and liabilities of the operating unit are notionally matched with the liabilities/assets of similar tenor, interest rate risk (IRR) is taken away to CFU. Hence an additional advantage of MFP is separation of IRR from operating units and centralization of the same at CFU. CFU takes over mismatch risk and is itself subject to performance measurement. Its profitability comes mainly from the management of mismatches.

MFP basically separates the interest spread earned by a bank into funding spread, credit spread and mismatch spread. If a branch raises two month deposit at 6 percent and ultimately the same is used to fund one year loan at 18 percent, the spread earned is 12 percent assuming, for simplicity purposes, no cost of reserve requirements. If MFP is implemented, this spread of 12 percent is bifurcated. If the 6 percent-deposit is assigned FTP rate of 9 percent, the funding spread is 3 percent. Similarly, an FTP rate of 14% for a loan with 18% interest rate gives credit spread of 4 percent. The remaining portion of the spread is mismatch spread. Thus the total spread of 12 percent is bifurcated into funding spread of 3 percent, credit spread of 4 percent and mismatch spread of 5 percent. The funding spread is earned by the branch raising the deposit, the credit spread is earned by the branch giving the loan and the mismatch spread is earned by CFU.

Choice of benchmark yield curve (money market rate) for determining transfer rates is an important step in MFP. In developed countries, interest rate swap (IRS) market acts as good benchmark as IRS market is essentially inter bank market representing cost of funds for banks. In markets without developed IRS market, the normal approach is to take yield curves of treasury bills and government bonds and adjusting the same for bank risk to arrive at representative cost of funds for a bank.

Normally, the money market rates are not adopted straightaway. Adjustments are made for factoring in cost of reserve requirements, insurance costs etc. In advanced MFP methodology, sometimes, cost of capital is also added to the money market rates to arrive at real cost of funding the assets.

Within MFP, a suitable method needs to be selected for each asset and liability. The choice of method depends on the repricing behaviour, cash flow characteristics, maturity pattern of each asset and liability. For example, a fixed deposit of two months raised by a branch will be paid a two months money market rate while each monthly installment of a loan will be funded through money market rates corresponding to the maturity of the installment. The first installment will be charged one month money market rate, 2nd installment two months money market rate and so on. For assets/liabilities without maturity dates average life is assumed based on statistical analysis and corresponding money market rate is assigned as FTP rate.

After assignment of rates, contribution of each asset liability is calculated and aggregated to work out the contribution of each product/customer/branch/segment for meaningful analysis and strategic planning. Due to its importance in asset liability management, central banks of some countries suggest that the banks should implement MFP.

The banks normally choose a method of FTP according to the level of sophistication desired, regulatory guidelines and available infrastructure in terms of skills and IT support. When implemented properly and in a scientific way, FTP enables an institution to appropriately price the products, accurately compare contribution of products, segments, branches, customers and manage assets and liabilities efficiently. Skilled manpower is a must for implementing a scientific FTP like MFP. In addition, existence of a strong IT and MIS infrastructure is a condition precedent.

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