Funds Transfer Pricing: a Worked Example

A bank's money comes from deposits, wholesale borrowing and its own capital, and goes out as loans, all on different terms. Without an internal price, nobody can say whether a three-year loan made a profit, because it was funded by a pool of deposits that might leave next month and bonds that run for five years. Funds transfer pricing cuts the link. Treasury charges each loan and credits each deposit as if each had been funded or invested separately in the market on the day it was made, and keeps the gap between the bank's actual funding and those internal prices as its own result.

Supervisors treat it as part of managing liquidity. The Basel Committee's 2008 liquidity principles ask banks to allocate liquidity costs, benefits and risks to all significant business activities. In Australia, the prudential regulator's liquidity guide for authorised deposit-taking institutions describes prudent practice as building funding and liquidity costs into internal pricing, performance measurement and new product approval.

The common method is matched maturity. The rate component follows how long the loan's interest is fixed: a floating loan that resets every 90 days is charged a 90-day market rate, a loan fixed for three years a three-year swap rate. The liquidity premium follows how long the bank is without the money: for a three-year loan, the extra the bank pays to borrow for three years rather than short term. A guide published by the BIS Financial Stability Institute in 2011 recommended pricing at the bank's marginal cost of funds matched to the product's maturity, managed centrally in group treasury, and charging activities that may need extra liquidity, such as undrawn commitments, for their expected use of it.

Deposits run the same arithmetic in reverse. A call account has no contractual term, so treasury credits it on an estimate of how long such balances actually stay, its behavioural maturity. Stable operating balances earn a better credit than money likely to move at the first rate change, which is where deposit beta enters the price.

A bank, constructed for this page like every figure in it, lends US$20m for three years to an aged-care operator, floating, resetting every 90 days, at the 90-day bill rate plus a margin of 2.20%.

Had the loan been fixed for three years, the rate component would be the three-year swap rate, say 3.95%, giving a transfer rate of 4.40% and a customer rate of 6.15%. The lending spread is the same 1.75%. The team is not paid for taking a view on rates; treasury hedges the fixed rate and owns the result.

Charging the loan at the 90-day rate alone would show a spread of 2.20%, US$90,000 a year richer. The three-year funding would still cost the bank its premium, but no team would see it, and loans of every length would look equally profitable. The operator's own call account of US$3m, paid 3.00% and credited by treasury at 3.40% on its behavioural term, gives the deposit team a spread of 0.40%, about US$12,000 a year.

The net interest margin is the bank's whole result: interest earned less interest paid, over its earning assets. Transfer pricing splits that result by who earned it. Broadly, the lending teams' spreads, the deposit teams' spreads and treasury's own result add back to the net interest income. Treasury's result is what remains after it has paid and charged everyone their transfer rates: a gain if it funded more cheaply than the curve it charged, a loss if funding costs rose before it could reprice.

That is why a change in method moves profit between teams without changing the bank's total. Raise the liquidity premium and the lending teams look poorer, treasury richer, and the bank exactly as profitable as before. What changes is behaviour: the teams now have a reason to price long loans and undrawn limits higher.

DEFINED IN ONE PARAGRAPH → · COST OF FUNDS → · THE QUESTION ON IT, TREASURY PAPER →

The borrower does not see the transfer rate, but it sees what it does. It is the funding line in the pricing floor a relationship manager cannot go below without approval, alongside expected loss, capital and costs. It is part of why a five-year loan carries a higher margin than a three-year one for the same borrower, why an undrawn limit attracts a fee, and why margins can move at a review when the bank's own term funding becomes dearer, even though the borrower's risk has not changed.

WHY YOUR BANK REPRICED YOUR LOAN → · HOW BANKS PRICE A BUSINESS LOAN →