Home > Uncategorized > Funds Transfer Pricing: How to Measure Branch Profitability

Funds Transfer Pricing: How to Measure Branch Profitability

Journal of Performance Management2006   by Kocakülâh, Mehmet C,   Egler, Michael

Introduction:

Today’s financial services industry is a highly competitive world. Banks are faced with competition from not only other financial institutions, but also, thrifts, insurance companies, investment companies, mortgage companies and others. Banks are facing immense challenges to achieve sustainable profitability. Historically low interest rates are compressing margins and forcing banks to enhance their performance management capabilities (Convery 2003).

One of the biggest measures of a bank’s profitability is its net interest income. Net interest income is by far the largest driver of product profitability, typically accounting for up to 80 percent of a bank’s revenue (Coffey, 2001).

Funds Transfer Pricing is an analysis tool that can be used to help a bank measure its profitability in a variety of different ways. It allows management to compare the profitability of different product lines within the company, and it can be drilled down even further to allow comparison between individual employees. It is also very useful for comparison between branches. This study will discuss the fundamentals of Fund Transfer Pricing (FTP) and talk about how Funds Transfer Pricing will affect the profitability of two branches of a bank.

Fund Transfer Pricing:

In simple terms, transfer pricing is"A transfer price measures the value of products furnished by a profit center to other responsibility centers within a company. Internal exchanges that are measured by transfer prices result in (1) revenue for the responsibility center furnishing (i.e. selling) the product and (2) costs for the responsibility center receiving (i.e., buying) the product." (Anthony, 2004). In the banking industry, this would be deposits that are collected by one branch and used by another to fund loans. This process is usually handled using an FTP system.

When a bank makes a loan to a customer, the funding for this loan has to come from one source or another. Typically, the funding in a financial institution will come from deposits collected by the bank. This type of funding is normally the cheapest and most desirable; however, when deposits are not sufficient to fund all the needs for cash that the bank has, the bank will have to get additional funding in the wholesale market. Therefore, each deposit brought in to the bank has a value to the financial institution for funding purposes, and, by the same token, a loan also has an underlying cost of funds and is not just interest income for the bank, as it would look in a typical income statement analysis. The purpose of FTP is to place a value on each deposit and assign a cost to each loan that a bank has.

When implementing an FTP system, banks’ must determine a "funding curve" that most reflects their source or use of funds on the wholesale market (Rice 2004). Many banks in the past used United States Treasuries as their funding curve. But recently, the government has dropped some buckets from its information. Therefore, many banks have switched to the LIBOR/Swap curve. The funding curve for a financial instrument shows the relationship between time to maturity and interest rate. Many banks make adjustments to these curves to customize the curve to fit the banks unique lending environment. The liquidity premium shown in Exhibit 1 is such an adjustment. This premium is added to the swap curve rate to calculate the total FTP rate, which in this case would be 4.22 percent.

Next, each loan or deposit that the bank has is assigned a rate based upon this adjusted funding curve. The rate that is assigned to these customer relationships will vary based upon the characteristics of the relationship. One characteristic that will cause a rate to change is time to maturity. For instance, a 5 year fixed rate note will be assigned a different rate than a 5year variable rate note. Also, for loans, the longer the term is to maturity, the higher the rate to fund that loan. For example, as shown by the yield curve in Exhibit 1, a fixed rate loan with a 5-year maturity would have a funding rate charge of 3.87 percent, whereas, a fixed rate loan with a 10-year maturity would be somewhat higher under a normal funding curve. By the same principle, a deposit that has a longer maturity would be assigned a higher funding rate credit because the bank is guaranteed the use of these funds for a longer period of time.

Looking at the 5-year fixed rate loan in Exhibit 1, it has a coupon rate of 6.00 percent and, based on the adjusted Libor/Swap curve, it would be assigned an FTP rate that is 4.22; therefore, the FTP spread is 1.78. Or in other words, the rate the loan is bringing in to the bank is 1.78 percent higher than the funding rate would cost the bank.

Other unique characteristics of a loan will cause the rate assigned to it to vary. One such characteristic is a prepayment option on a loan. As shown in Exhibit 2, a prepayment option will change the average expected life of the loan. This is an assumption that is based on looking at historical trends in the bank. In this example, the average life of a 5-year fixed rate, prepayable loan with a coupon rate of 5.50 percent is determined to be 3.2 years. The Libor/Swap curve rate to fund this loan is 3.49 percent. The liquidity premium is .25 percent and an option premium of .55 percent is added for the prepayment option to come up with an FTP rate of 4.29. This would give an FTP spread of 1.21 percent.

Once all the data is input into the FTP system, management will have to decide how often the rates will be assigned. This may be done monthly, weekly or sooner depending on the capabilities of the system and the needs of management for decision making. Large amounts of data must be stored and many calculations must be made for an FTP system to provide useful information for management. In the past, the technological hardware and software used within banks were not of sufficient power or flexibility to handle the data volumes involved or provided the analytical capabilities demanded. Today, however, such technology is available, enabling the appropriate levels of contract-level detail handling and providing the ability to analyze data across any number of dimensions in ad hoc fashion (Convery,2003).

Using FTP to measure Branch Profitability:

Financial Institution’s income statement is designed to calculate net-interest income for the entire organization. It is not designed to calculate the net-interest income of one product (Coffey2001). This is also true of calculating the net interest income of branches for comparative purposes. Branches within a bank are almost never the same in terms of loans and deposits. Some branches are heavy on the loan side, while others are heavy on the deposit side and still others are fairly evenly balanced. Determining the profitability of individual branches in a traditional accounting sense is extremely difficult. Looking at an income statement for a branch using a typical accounting analysis, interest collected from loan payments are shown as interest income and interest paid out on deposits are shown as interest expense. But this does not take into account that deposits have a positive value to the bank by providing cheap funding for its loan purposes. Conversely, it also does not take into account that a loan has an underlying funding cost associated with the process of making the loan. Therefore, using a typical income statement format, a branch that is heavy on the deposit side will look like it is losing money, while a branch that is heavy on the loan side will look like it is highly profitable. This can be shown in Exhibit 3, which looks at net interest income for two branches

As shown in Exhibit 3, from this example, the branch that is providing a lot of low cost funding for the rest of the bank’s funding needs shows a loss on net interest income. At the same time, the branch that has a lot of loans but not as many deposits, and therefore, has to borrow excess deposits from other areas of the bank to fund these loans shows a high net interest income. What does this information show to management?

Would management think that Branch A is not profitable? Probably not, a bank’s management knows that just because a branch has more interest expense because of a large volume of deposits, doesn’t mean that it is unprofitable. These deposits are necessary for the funding needs of other areas of the bank. However, determining the true profitability of either bank is extremely difficult, and being able to compare either branch is next to impossible. This is where FTP becomes extremely useful. Using the FTP system will charge a cost of funds to all the loans that each branch has and will give a funding credit to all deposits that each branch has. This will help to determine the true profitability of each branch and will allow for comparisons between different branches. see exhibit 4 and 5.

Applying FTP rates to these two branches significantly changes the profitability picture of each compared to the traditional income statement approach. Branch A, which originally showed a net interest income loss of (25,589), now shows a profit of 20,829. This gives management an accurate picture of the actual value that Branch A, adds to the company. The low cost funds provided to the bank by Branch A is valuable to the bank by decreasing the wholesale funding that would be necessary otherwise. In comparison, Branch B, which originally showed a net interest income of 1,150,002, now shows a net interest income of 50,310. This is a substantial decrease in its net interest income. The branch now has to pay for the funds that it is using to make its loans.

Another way for management to look at the profitability of its branches is to look at the spread between the coupon rate and the FTP rate for each branch. This shows how well a branch is pricing its products. When looking at the spread between the coupon rate of an account and the FTP rate assigned to that account, the greater the spread, the more income per dollar, the account is providing to the bank. By frequently updating the assignment of FTP rates, management has a valuable tool to make pricing decisions for all its products.

Management can also use the spread as a comparison between branches. For instance, looking at Branches A and B in Exhibit 4 and 5, one can see how this can level the playing field between branches of different sizes. If one look at the dollar amounts for loans, for these branches, one would see that the interest income for loans for Branch A is $5,755 and the interest income for loans for Branch B is $33,870. There is a large difference between the two branches. However, this picture is somewhat distorted because Branch B is much larger that Branch A. A better way to compare the performance of the two branches would be to look at the spread on loans for each branch. Looking at the spread will factor out the loan volume and give a clearer picture of dollar for dollar how the two branches compare. Looking at the information in this manner, one can see that Branch A, actually brings in more income for each dollar of loans generated than Branch B, does. The loan spread for Branch A is 2.67 percent, while the loan spread for Branch B is somewhat lower at 1.84 percent. This means that for each loan dollar, Branch A generates 0.83 percent more income than Branch B.

One thing that management must be wary of when looking at the spread is economic factors in different areas that are beyond the control of the branch manager. For instance, Branch B may be in a location that has a number of competitive banks in its immediate region. To stay competitive and survive in this type of condition, the branch may be forced to earn a lower spread on its loans to bring in new business. So, although FTP allows for easier comparisons between different branches, as with all management tools, there are other factors that must be considered. Being able to factor out dollar volume and level the playing field between branches of difference sizes, FTP gives management a powerful tool for setting performance goals. By looking at the spread, management can make the volume portion a separate piece of compensation. In some compensation packages, the amount of additional compensation is only tied to the amount of loan volume produced for a given period. By using FTP spread as a part of the performance qualifications, upper management can help ensure that loans are being under priced to reach performance goals.

Funds transfer pricing is a powerful accounting tool available to management for profitability analysis. It allows management to make informed decisions on product pricing. It allows for profitability comparison and analysis among branches of various sizes. It also helps to level the playing field when looking at branches that have very different loan and deposit mixes. It helps branch managers make sound lending decisions by showing the cost of funds associated with making loans, and it shows the value that low cost deposits add to the company. Like any management tool, it should not be utilized to the exclusion of all other tools and methods of analysis and decision making. However, used in conjunction with other information, funds transfer pricing offers management a vast array of useful information in its decision-making and analysis process of their financial institutions.

FOOTNOTES:

1. Net interest income is defined as the difference between its interest income (generated from earning assets) and its interest expense (paid on deposits and other borrowings).

2.Wholesale borrowings normally consist of Federal Home Loan Bank advances, federal funds, brokered CD’s, repossession agreements and borrowings from other financial institutions.

3. For comparative purposes, non-interest income and non-interest expense was left off the income statement

REFERENCES:

Convery, Shawn, "Keeping banks competitive: a foundation for robust performance management’, Balance Sheet, 2003, Volume 11, Issue 3.

Coffey, John J., "What is fund transfer pricing", ABA Bank Marketing, November 2001, Volume 33, Issue 9.

Rice, Jennifer D., and Mehmet C. Kocakulah, "Funds Transfer Pricing A Management Accounting Approach within the Banking Industry", Journal of Performance Management, 2004, Volume 17, Issue 2.

Payant, Randall W., "To FTP Or Not To FTP – That is The Question", Journal of Performance Management, 2004, Volume 17, Issue 2.

ShLh, Andre, David Crandon, and Steven Wofford, "Transfer Pricing: Pitfalls of Using Multiple Benchmark Yield Curves", Journal of Performance Management, 2004, Volume 17, Issue 2.

Anthony, Robert N., David F. Hawkins and Kenneth A. Merchant. Accounting Text & cases. New York: McGraw Hill, 2004.

Interview, DelosSantos, Allan, Treasurer-Integra Bank Corporation, March 18, 2005.

Mehmet C. Kocakülâh

* University of Southern Indiana

College of Business

University of Southern Indiana

8600 University Blvd.

Evansville, IN

47712812.464.1730

Fax: 812.465.1044

email: mkocakul@usi.edu

Michael Egler

Senior Financial Analyst

Integra Bank Corporation

Evansville, IN 47711

(812)464-9866

email: megler@integrabank.com

* Correspondent author

Kocakülâh, Mehmet C "Funds Transfer Pricing: How to Measure Branch Profitability". Journal of Performance Management. FindArticles.com. 12 Mar, 2009. http://findarticles.com/p/articles/mi_qa4148/is_200601/ai_n16431094

 

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