Bank Internal Funds

Transfer Pricing (FTP)

Elton Tam
PhD, DBA, MSc, BSocSc (Hons)
CPA/CA qualified in H.K., China, U.K., U.S. and Canada

26 October 2013
City University of Hong Kong

Agenda

Introduction
Objectives of FTP
FTP Approaches
Common Practice
Some Technical Remarks

Agenda

Introduction
Objectives of FTP
FTP Approaches
Common Practice
Some Technical Remarks

Bank Funds Flow

Banks are institutions that serves as the
financial intermediaries in the economy.
They are responsible for funds flow within
the nation's economy.

Funds
Deficit Unit

Deposittaking

Lending

Bank
.

Funds
Surplus Unit

Balance Sheet of a Bank

Assets :

Cash
Inter-bank placements
Loans

Investments

Mortgages
Trade Finance
Term loans

FV through P/L
Available for sale
Held-to-maturity
Loans & receivables

Other Assets

Liabilities :

Inter-bank borrowings
Deposits

Current accounts
Saving accounts
Fixed Deposits

Issued debts
Retained profits
Reserves
Share capital
Other Liabilities

Performance Measurement

Assume a bank has only one asset ($100mn)

and one liability ($100mn).

Asset
e.g. a $100 million 5-year
term loan

Interest income = 3.0%

Liability
e.g. a $100 million 2-year
fixed deposit

Funding credit = ??
(i.e. FTP credit)

Less : Funding cost = ??

(i.e. FTP charge)

Less : Interest expense = 1.5%

Net interest spread = ??

Net interest spread = ??

What is FTP?
Funds transfer pricing (FTP) is a process used in
banking to measure the performance of
different business units of a bank. A bank could
have different kinds of businesses. Most
important businesses are deposit-taking and
funds-advancing. 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. FTP is a mechanism to
measure the relative contributions to the bank's
profitability and hence shareholder's value.
(Wikipedia, with modification on some terms.)

Agenda

Introduction
Objectives of FTP
FTP Approaches
Common Practice
Some Technical Remarks

Key Objective
The Banks funds transfer pricing policy is
to establish a framework of performance
measurement and profitability
assessment for all products of the Bank
which distinguishes their difference in
repricing behaviour in order to manage
interest rate risk and their difference in
the time span of occupying funds in order
to mange liquidity risk.

Objectives & Applications (1)

Centralize the management of interest rate

risk and liquidity risk.
Divide the commercial responsibilities of
business units from the financial
responsibilities of a dedicated function
(normally named as internal clearing centre, of
which the responsibilities are commonly taken
up by Treasury/ALM). In this regard, a
business unit is responsible for the margin to
be earned from its products upon the actions
solely under its control.

Objectives & Applications (2)

Measure profitability of each kind of asset

and liability, hence for each business unit
also, with interest rate risk excluded and
liquidity risk adjusted.
Prepare business plan and set profitability
budget/target for each kind of asset and
liability, hence for each business unit.
Provide guidance for product pricing.
To allow the netting of liquidity deficits
against liquidity excesses within the bank.

Difficulties

FTP process is a zero-sum game among

different business units. Their goals may conflict
with one another. Typically, the FTP solution
adopted is the result of negotiation.
There may also be conflicts between the goals
of a business unit and the bank as a whole. The
FTP method should encourage managerial
behavior to align with the banks strategy.
Apart from the theoretical aspect, also need to
consider the practical aspect. Theoretical
concepts may be difficult to implement in practice.
It may not be able to obtain relevant market data
to determine the FTP rates.
No one-size-fits-all solution.

Agenda

Introduction
Objectives of FTP
FTP Approaches
Common Practice
Some Technical Remarks

Commonly Used Approaches

Reimbursement

Approach
Internal Clearing Centre Approach

Reimbursement Approach

A simple rudimentary approach.

Overall actual average funding cost is
quantified and charged to interest bearing
assets.
Drawbacks :

No consideration of interest rate risk

No consideration of liquidity risk

An approach that may be adopted by banks

for a business which operational scale is
small (e.g. a newly established branch).

Reimbursement Approach
Assets :

Loans
Investments

Liabilities :
Yield

CoF

3.5%

1.5%

2.5%

1.5%

Deposits
Inter-bank (net)
Debts issued
Retained profits
Reserves
Share capital
Overall cost of funds = 1.5%

Internal Clearing Centre Approach

A centre is dedicated for clearing funds which

provides funds required by assets and deploys
funds generated by liabilities.
The clearing centre is the banker within the
bank.
Most, if not all, interest rate risk and liquidity risk
are transferred to the clearing centre in order to
allow risks to be centrally managed.
Typically, Treasury (or its ALM Desk) is
designated as the clearing centre.
An approach commonly adopted by most banks
for full blown operation.

Internal Clearing Centre Approach

ALCO

Wholesale
A

Supervision
FTP
Risk Transfer

Internal Clearing Centre

Retail
A

(Treasury/ALM)
FTP
Risk Transfer

Corporate
A

Markets
Pricing
Risk Transfer

Performance Measurement (Example)

Assume a bank has only one asset ($100mn)

and one liability ($100mn).

Asset
e.g. a $100 million 5-year
term loan

Interest income = 3.0%

Liability
e.g. a $100 million 2-year
fixed deposit

Funding credit = 1.8%

(i.e. FTP credit)

Less : Funding cost = 2.0%

(i.e. FTP charge)

Less : Interest expense = 1.5%

Net interest spread = 1.0%

Net interest spread = 0.3%

FTP Charge/Credit with the

Internal Clearing Centre

Splitting of the total spread 1.5% (3.0% - 1.5%) among the

earning asset, costing liability and internal clearing centre.

FTP Charge/Credit with the

Internal Clearing Centre
3.0%

2.0%
1.8%
1.5%

2Y

5Y

Agenda

Introduction
Objectives of FTP
FTP Approaches
Common Practice
Some Technical Remarks

Risk Elements Considered for

Determining FTP Charge/Credit
The overall FTP rate should take
into consideration the following
risk elements :

Interest rate risk

Liquidity risk

Interest Rate Risk vs. Liquidity Risk

Consider the following loans and
compare the exposures in interest rate
risk and liquidity risk :
A.a 3-year term loan with fixed rate at
4%
B.a 3-year term loan with 3-month
floating rate at 3M Hibor+200bps
C.a 1-year term loan with 3-month
floating rate at 3M Hibor+150bps

Interest Rate Risk vs. Liquidity Risk

Loan A vs. Loan B
Interest rate of A is locked for 3 years but
interest rate of B is repriced every 3
months.

Interest rate risk of A > B

Both loans need to be financed for 3 years

and occupy funds for 3 years

Same burden for liquidity risk

Interest Rate Risk vs. Liquidity Risk

Loan B vs. Loan C
Interest rate of both B and C are repriced
every 3 months.

Same interest rate risk

B needs to be financed for 3 years and

occupies funds for 3 years whereas C
needs to be financed for 1 year and
occupies funds for 1 year only

Liquidity risk of B > C

Interest Rate Risk vs. Liquidity Risk

Loan A vs. Loan C
Interest rate of A is locked for 3 years but
interest rate of C is repriced every 3
months.

Interest rate risk of A > C

A needs to be financed for 3 years and

occupies funds for 3 years whereas C
needs to be financed for 1 year and
occupies funds for 1 year only

Liquidity risk of B > C

Transfer of Interest Rate Risk

Repricing Profile of Assets

1M
3M
6M
9M
1Y
2Y
3Y
4Y
5Y

Transfer of
Interest Rate Risk

Internal Clearing Centre

Repricing Profile of Liabilities

1M
3M
6M
9M
1Y
2Y
3Y
4Y
5Y

Transfer of
Interest Rate Risk

(Treasury/ALM)

Markets

Cost of Funds Curve - Interest Rate Risk

1M
3M
6M
9M
1Y
2Y
3Y
4Y
5Y

COF Curve

Market Curve
1M
3M
6M
9M
1Y
2Y
3Y
4Y
5Y

Construction of COF Curve (1)

Typically, COF curve is constructed using inter-bank

money and swap market rates, based on the
assumption that Treasury (as the clearing centre) can
freely tap (if in deficit) and deploy (if in surplus) funds
from/to market.
Since 2008 after the Financial Crisis, inter-bank rates
have been exceptionally low. Coupled with the twists
caused by the Quantitative Easing (QE) of the US,
Europe and Japan, inter-bank rates continue to be lower
than deposit rates.
If FTP credit offered to deposit funds are based on
inter-bank rates, the interest spreads are negative.

Construction of COF Curve (2)

Modification : The curve is adjusted to reflect the banks

marginal cost of funds for each point across the interest
rate term structure.

Marginal cost of funds is the marginal cost of borrowing.

The Internal Clearing Centre is regarded to be representing
the bank to borrow funds from the banks liabilities and lend
funds to the banks assets.
Pricing of the banks borrowing
= Risk-free rate (or reference rate) + the banks credit spread
(without considering liquidity premium)
The banks credit spreads for different tenors can be
obtained or deduced by :
If the bank is an active issuer of debts, credit spreads of the
debts recently issued by the bank.
Using the credit spread curves published by rating agencies
for financial institutions that correspond to the rating of the bank.

Transfer of Liquidity Risk

Maturity Profile of Assets

1M
3M
6M
9M
1Y
2Y
3Y
4Y
5Y

Transfer of
Liquidity Risk

Internal Clearing Centre

Maturity Profile of Liabilities

(Treasury/ALM)

1M
3M
6M
9M
1Y
2Y
3Y
4Y
5Y

Transfer of
Liquidity Risk

Markets

Liquidity Premium Curve Liquidity Risk

1M
3M
6M
9M
1Y
2Y
3Y
4Y
5Y

LP Curve

Market Curve
1M
3M
6M
9M
1Y
2Y
3Y
4Y
5Y

Construction of LP Curve (1)

The Liquidity Premium Theory of yield curve

asserts that long-term interest rates not only
reflect investors assumptions about future
interest rates but also include a premium for
holding long-term bonds (investors prefer short
term bonds to long term bonds), called the term
premium or the liquidity premium.
In this regard, interest rate of a debt instrument
can be perceived as :
Interest Rate = Risk-free rate (or reference rate) +
Credit spread of the issuer + Liquidity premium for the
investment tenor

Construction of LP Curve (2)

Refer to an early example :

a 3-year term loan with 3-month floating rate

at 3M Hibor+200bps
a 1-year term loan with 3-month floating rate
at 3M Hibor+150bps

The first loan that will hold up the funds for

two more years, as compared to the
second loan, needs to provide 50bps
additional liquidity premium.

Construction of LP Curve (3)

Liquidity premium of assets with different

tenors, hence the LP curve, can be
obtained or deduced by :

Comparing the interest rates of different

assets with different tenors but have same
credit risk.
Using the liquidity premiums estimated by
rating agencies for issued instruments that
correspond to the rating of the asset.

Agenda

Introduction
Objectives of FTP
FTP Approaches
Common Practice
Some Technical Remarks

Some Technical Remarks (1)

Banking is a multi-currency business with

assets and liabilities denominated in different
currencies.
Since interest rate risk and liquidity risk of
different currencies are different, each currency
has its own COF curve and LP curve
constructed.
FTP credit/charge and liquidity premium are
applied to assets/liabilities based on the
currency denomination, using the respective
currency COF curve and LP curve.

Some Technical Remarks (2)

The core elements of FTP rates include
cost of funds rate and liquidity premium.
May consider to make further adjustments
for liquidity to include the cost of
liquidity incurred because of the need to
hold a sufficient cushion of high quality
liquid assets for regulatory or prudential
purposes (i.e. contingent liquidity
spread).

Some Technical Remarks (3)

Interest rate risk should be determined
based on the repricing behaviour of the
assets and liabilities.
While the repricing cycles of some assets
and liabilities are explicit from their
contractual terms, it would only be able to
identify the repricing behaviour of the
others through analytical behavioural
studies.

Some Technical Remarks (4)

Calculation of FTP charges/credits :

Deal-by-deal basis vs. Portfolio basis

Deal-by-deal basis : if each deal is material,

and repricing cycle for COF and maturity for
LP can be clearly determined from the
contractual terms.
Portfolio basis : otherwise.

Some Technical Remarks (5)

FTP credit for equity :

Equity (mainly share capital or retained earnings)

of a bank is a source of funds.
No matter the funds are employed by
Treasury/ALM (internal clearing centre approach)
or by some assets (reimbursement approach),
there should be FTP credit to equity to reflect the
opportunity cost of employing the funds
Commonly used FTP credit rate for equity :
Return on equity (ROE)
Average FTP credit rate of all other liabilities, as an
rule-of-thumb approximation.

Some Technical Remarks (6)

FTP for non-interest bearing assets/liabilities :

Difficult to determine their repricing behaviour and

maturity.
These items are normally small as compared to interest
bearing items. Not justifiable and not practicable to
spend too much efforts on these items.
Apply FTP charge to an asset with no yield always gives
a negative margin and apply FTP credit to a cost-free
liability always gives a positive margin. Not meaningful
for the purpose of performance measurement.
Commonly used method :
Net off the non-interest bearing assets and liabilities.
If it is a net liability, apply average FTP credit rate of all
other liabilities. If it is a net asset, apply average FTP
charge rate of all other assets. As the overall funding
positions (sources vs. applications) of the bank should be
balanced.

Some Technical Remarks (7)

Importance of FTP in the calculation of

RAROC :

RAROC = Risk Adjusted Return on Capital

RAROC is a risk-based profitability
measurement framework for analysing riskadjusted financial performance and providing
a consistent view of profitability across
businesses. (Wikipedia)

RAROC

Income Expense Expected _ Loss Income _ from _ Capital

Risk _ Capital
FTP

Wrap-up

FTP is a process used in banking for performance

measurement and profitability assessment of assets,
liabilities and business units.
The process should centralize the management of
interest rate risk and liquidity risk.
Conflicts exist among different business units and
also between the goals of each business unit and the
bank as a whole. The method should encourage
managerial behavior to align with the banks strategy.
The theoretical concepts may be difficult to implement in
practice. Apart from the theoretical aspect, it is
necessary to consider the practical aspect also, in
particular the difficulty in obtaining sufficient relevant
market data to determine the FTP rates.
To conclude, the design of a FTP framework is both a
science and an art.

Thank You !

Q&A

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