Dr. Judit Burucs is Project Manager, for IFC, Russian Banking Advisory Project.

Prior to IFC she worked as the Managing Director for OTP Group in Budapest. She was responsible for the Groups level managing country, counterparty risk and market, liquidity, and interest rate risks.

THOUGHTS ABOUT EMPLOYING FUND TRANSFER PRICING

[Dr. Judit Burucs, April 10, 2008]

Internal Fund Transfer Pricing (FTP) is a well known practice in the financial sector, it is part of the overall management information, accounting and control system which includes pricing, budgeting profit planning and asset and liability management. Through fund transfer pricing a bank can analyze more efficiently its net interest margin, because fund transfer pricing allows for quantifying the variances caused by imbalance of funds provided and funds used by the bank. The following types of FTP methodologies are utilized by the financial institutions1: 1. Single Pool Rate Matching utilizes one rate to credit all fund providers and debit all fund users, respectively. This rate might be the weighted average cost of funds for the reporting institution, prime rate, or some other capital market rate. The single pool approach is simple, but does not take into consideration any maturity or imbedded risk characteristics. 2. Specific Matching is a mostly academic approach. The objective of specific matching is to match every specific liability with every specific asset of an equal amount, maturity and imbedded risk characteristic. 3. Multiple Pool Rate Matching is an extension of single pool rate transfer pricing. Essentially, each side of the balance sheet is split into pools of assets and liabilities sorted by criteria such as maturity characteristic, rate and yield, imbedded risk, or credit factors. Then the pools from each side of the balance sheet are matched to the opposite side of the balance sheet to establish a related funds charge or credit. 4. Matched Maturity is basically a gap approach. Each individual customer account is matched to a market driven index such as the Treasury Yield Curve, the swap curve, or LIBOR (London Inter-Bank Offer Rate) based curve. Transfer pricing rates should represent the alternative opportunity rate for the banks sources or use funds and vary according to repricing term and other attributes. The Matched Maturity has become the preferred approach to Funds Transfer Pricing because Business units are more willing to accept FTP when transfer prices have a transparent, rational basis and are applied consistently throughout the organizational structure and across timelines. Marginal spread for each product is accurately measured. The earning attributable to interest rate mismatching is correctly identified. Each product spread is independent of any other balance sheet element.

Keys to community bank success: Utilizing management information to make informed decisions-Funds transfer pricing (FTP) , Journal of Bank Cost & Management Accounting, 2001, by Katafian, Robert E.

The main objective of this article is to provide a brief introduction of the Matched Maturity Fund Transfer Pricing approach, and to highlight the specifics of its application to the Russian Financial Market.

I. BASICS OF THE FUND TRANSFER PRICING I.1.The process FTP creates a shadow2 of assets and liabilities for each expected cash flow item on the balance sheet and attaches to each a market price respective of its particular terms. Real assets are accordingly funded by shadow liabilities to produce a matchfunded spread; conversely, real liabilities receive income from shadow assets for the same purpose. A unique charge or credit rate is assigned to each record according to its origination date on the basis of repricing tenor, contractual cash flow and some adjustment (repricing spread, liquidity term, embedded option and etc.) In the process, the lending and deposit units obtain a leveled balance sheet and a net interest spread per record is established. The FTP posts mismatched earnings from business units into a special Funding Mismatch Unit. This unit can be the Treasury, Funding Center or ALCO in practice. The Funding Mismatch Unit acts as the central clearing house for funds, benchmarking all transfer rates against a market derived yield curve plus other market pricing factors. Calculated debits and credits are applied to book balances until the earlier of maturity or repricing. If the bank uses a single yield curve, so asset and liability transactions of identical attributes are assigned an identical transfer rate. When measuring performance, a transactions transfer rate remains unchanged over its repricing life. Effectively, this insulates the transactions margin contribution from the effect of subsequent market interest rate changes. A simple example will illustrate this process. Let us assume that the institution has only two items on its balance sheet: 3 year duration deposit on which it pays 6,5 % interest rate and a 8 year duration mortgage on which it receives a 10 % interest rate. A net interest margin is 3.5 % (10%-6.5%). Assume further that the bank is asset rich (it possesses more loan than deposits) and can borrow in the wholesale market at 7 % for 3 years and 8 % for 8 years. The FTP allows the institution to split up its 3.5 % net interest margin into a 2 % net interest margin on loan (10%-8%) , a 0.5% net interest margin on deposit (7%-6.5%), and interest rate risk mismatch of 1 % (8 %-7%). I.2. Funding curve Selecting a transfer pricing yield curve is a critical aspect of the FTP. Should we use the Funding rate or the Investment rate? When implementing a FTP system banks must determine a funding yield curve that most accurately reflects their source or assets on the whole sale market. Some banks may utilize an interbank rate such as LIBOR, interbank SWAP curve, or
A banks focal point for market risk: The transfer pricing mismatch unit, Journal of Bank Cost & Management Accounting, 200 by Chittenden, John
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a treasury yield curve. Using credit risk free market indices like a treasury yield curve will encourage banks to make loans that are less profitable than they appear and to discourage deposits that can be profitable. Another methodological choice that banks currently face is the decision to apply single or multiple benchmark yield curves. Mr. Shih 3 proved that while the multiple curves option may appear desirable at the first glance, the actual use of a multiple curve methodology will have serious and detrimental consequences for FTP program as misallocation of resources, inconsistent margin comparisons among products, inaccurate measurement of the total interest rate risk of the institution and improper inclusion of credit risk in interest rate risk. Furthermore bank should apply a separate benchmark yield curve to each of the currencies in which it operates, because each of the currencies in which a bank deals represents a distinct and independent source of interest rate risk. Interest rate in European Union, Russia or USA may shift in opposite direction for completely unrelated reasons. I.3. Adjustment for other factors beyond the benchmark The funding curve for a financial instrument shows the relationship between different indicators such as time to maturity and the interest rate. Adjustments to a base FTP4 yield curve are often necessary to reflect unique attributes of the particular institution and instrument. The most common adjustment methodologies will be introduced in the following section. The decision to apply a certain method to use should coincide with the banks own cultural and fundamental principles which are the follows: 1. Institution Credit Risk Adjustment: If the bank is not deposit rich, the base yield curve needs to be adjusted to reflect the banks own credit risk. There are some banks that use their own actual senior debt market spread. 2. Bid/Asked Spread or Funding Commission Adjustment: The brokering cost (commission or fee) can be factored into the transfer pricing yield curve. Typical products for this approach are all assets and liabilities managed by a treasury department of a bank. 3. Term Liquidity Adjustment: Term liquidity is the impact of the repricing frequency of an instrument being shorter than expected maturity. The liquidity premium can be estimated by observing rate differentials between the organizations wholesale funding curve and swap curve. Swap rates quote the cost to transfer interest rate risk, so differences between actual funding rates and swaps represent the cost to raise physical liquidity, less term repricing risk. For example the market prices fixed rate 90 days commitments differ from floating rate commitments with 90 day repricing. The difference is the liquidity premium. Adjustment can be made by debiting a tem liquidity premium to floating (variable) rate assets based on their contractual or
Transfer pricing: Pitfalls in using multiple benchmark yields curves , Journal of Bank Cost &Management Accounting,2000, by Shih, Andre 4 : Adjustments to the base FTP rate index curve, Journal of Bank Cost & Management Accounting, by Ersoz, Ali Murat Transfer Pricing, Financial Risk management in Banking, Therory &Application of Asset &Liability Management MCGRaw-Hill, by Dennis G. Uyemura, Domald R. Van Deventer
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4. 5.

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expected average lifetime and assigning a credit to floating (variable) rate liabilities based on their contractual or expected average lifetime. The adjustment (specific amount of the spread) can be made by applying historical rates. Adjustment to the base yield curve are necessary for instruments that have the same duration or repricing period, but due to different liquidity characteristics are not of the same value or cost to the bank. A fixed rate loan with 5 year duration may receive a lower FTP charge than a similar asset with the same duration due to the ability of the bank to convert the loan into a more liquid investment, by using a secondary market for securitization. Option Pricing Adjustment: is used to reflect the cost of providing the customer an right to unilaterally change the contractual terms of a transaction. Prepayment Penalty Adjustment: can be incorporated and applied in transfer pricing in two ways: The first way is the after transaction that is applicable to larger-sized transactions, especially where an economic prepayment fee is charged to the borrower. Transfer rates are assigned based on the contractual amortization or maturity schedule. When a prepayment occurs, the original transfer fund are sold back to the Treasury with the mark to market prepayment loss (or gain) passed to the business line unit in the form of a cost allocation. The second way is for transactions that are used for loan products where there is generally no prepayment penalty charged. (e.g. mortgage loan). The FTP is increased by an amount that will compensate the Treasury over the expected average life of such loans for the prepayments that will occur. Mandatory Reverse Deposit Requirement Adjustment: is the lost interest on the deposit without interest or lower interest that needs to be held in the Central bank by the bank. Interest payment Adjustment: The banks should adjust their funds transfer price to an interest payment frequency. A funds transfer debit or credit adjustment is to be made for all interest earning and interest bearing products which interest payment frequency is different from the basic yield curve. Others adjustments: can also be made though are not common in practice. Among them are: Tax Advantage Adjustment for fixed asset in auto or commercial leases, or Stand by Liquidity Adjustments.

I.4. Adjustment or transfer pricing in the case of indeterminate maturity deposits and non interest bearing assets Every source and use of funds does influence the margin. Some are interest bearing, others are not. Capital, cash and fixed assets are non-interest bearing accounts. According to Randall5 after considering the value and relevance of transfer pricing non-interest related balance sheet positions, in most cases, it's quite a useless exercise.

To FTP Or Not To FTP - That is The Question!, Journal of Performance Management , May 1 2004, By Payant, W Randall

In the case of the indeterminate maturity deposit especially in the case of demand deposits finding the appropriate FTP is a real challenge and the bank should find it own way. The current rate6 method, the average rate methods and the blended term approach are well used. 1. The current rate method transfer prices the deposit at rates that are in place for the current processing period. Changes in market rates are immediately and fully reflected in assigned transfer rate. 2. The moving average methods, a form of the average rate transfer pricing, intends to describe the sluggish pricing observed for these types of liabilities. A time period for the moving average is chosen based on the observed or estimated repricing responsiveness for the deposit category. 3. Blended term analysis initiates by assuming a portion to a product line as core stable based on historical analysis of past cash flow patterns in balances. Non volatile balances profiles secure longer moving averages. Balance and time segmentation continues until some amount is apportioned to a volatile portion which receives a short transfer rate. Blended term transfer rate is a weighted transfer price with cash flow. I.5. Using the FTP for performance forecasting and measuring branch profitability The FTP can assist the convergence of the Asset and Liability Management (ALM) and the budget planning7. Transfer prices can help forecasting 8 margin performance of business units. Additionally, the residual spread between the interest rate and transfer rates can be used in simulating funding center strategies and measuring mismatched risk exposure. Managers want to forecast their business units net interest contribution especially in the budgeting process. When they project the future balance sheet, they can be assisted by a simulation tool based on the FTP which models balance sheet and interest income/expense behaviors, separating the future impact of existing business from planned, new business. The model needs information about the cash flow, repricing, maturity, currency, embedded option and other characteristics of existing business. This simulation model provides then forecast of a business units pre-ordained interest margin based on it existing book of business. Business unit managers can project the additional new business volumes that must be booked, at appropriate margins, to meet their overall net interest contribution target. The business units simulation forecast are rateenvironment sensitive, managers can understand and consider rate-dependent volume effects on their business performance. The originating units net contribution to the overall recorded margin of the bank is a traditional historical post performance measurement view. The FTP cannot eliminate all effects of interest rate changes from originating business units or unscheduled volume reductions. Rate-volume variance analysis must consider this element. FTP only insulated the origination units performance from the effects of pricing risk, not volume risk.
Transfer pricing Indeterminate-maturity Deposits, Journal of Performance Management, by Thomas E. Bowers Better financial planning with balance sheet modeling, Journal of bank Cost & Management Accounting, 2000, by Eastburn, Stephen. 8 Fund transfer pricing and A/L modeling, Journal of Bank cost & management Accountant, 2000, Payant, W Randall.
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After allocating the contribution margin based on transfer prices, any residual spread is credited to a funding center. This spread is what the bank earned from accepting funding mismatches. In aggregate, though, sources and uses of funds in the balance sheet create numerous funding mismatches. The residual spread provides limited information about the aggregate balance sheet mismatch to which the bank is currently exposed. This is because it is derived from transfer price assigned at interest rate setting. To understand and measure the earnings impact on the funding center of the existing mismatch, transactions remaining-term transfer price need to be used. A transactions remaining term transfer price is the price that would be assigned today based on it is remaining repayment characteristic and todays alternative yield curve so, the spread between the different points of the curve indicates how much could be earned for accepting mismatches today. To analyze the banks aggregate existing mismatches, the remaining term transfer price is applied to the transfer priced principal balances for all sources and uses of funds. The overall mismatchs impact on future earnings can be evaluated in an income simulation model. This procedure isolates only the funding mismatch components in the simulations funding risk assessment. The income simulation of the funding mismatch assists the funding center in its management. The difference between the origination term and remaining-term simulation results represents the spread the bank created from two factors- first accepting prior mismatch exposures, whose effects on earnings may not be felt immediately and secondly because transactions remaining lives shorten over time. The planning usually focus on a single most likely scenario for interest rates and assumption such as prepayments while ALM mutually tests the future balance sheet and net interest revenue projections across numerous and varying assumptions . Income simulation can be performed with different assumption for interest rates, prepayments, volume growth, spreads, etc. Rules can be created to automatically calculate new business assumptions based on other assumption or result. FTP should remove future interest rate risk planned business unit net interest revenue and yield a mismatch calculation which is very meaningful for a Treasury department. Transfer pricing can help to measure and compare the branch profitability9. Branches within a bank are almost never the same in terms of loans and deposits. Some branches are rich on the loan side, while others are rich on the deposit side or are fairly balanced. Determining the profitability of individual branches in a traditional accounting sense is difficult; because a branch is heavy on the deposit side will look like it is losing money, while a branch that heavy on the loan side will look like it is highly profitable. However, determining the true profitability of branch is difficult. 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. Management must be cautious when
Fund Transfer Pricing: How to Measure branch Profitability, Journal of Performance Management, by Mehmet C. Kocakulah,
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looking at the spread is for economic factors in different areas are beyond the control of the branch manager. For example, Branch A 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 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. II. WHAT ARE THE SPECIFICS OF USING FTP I NTHE RUSSIAN MARKET? II.1 Funding curve for ruble denominated assets and liabilities Selecting a transfer pricing yield curve is a critical aspect of the FTP. This is a challenge for the Russian market, because there is still no real wholesale market or liquid bond market for longer maturities than 2-3 years. If the bank is rich on the deposit side, it can choose an investment yield curve as a transfer pricing yield curve. The potential investment curve could be the followings: The treasury bond yield curve Rate of the bonds issued by the Agency for Housing Mortgage Lending10 ("AHML") because it is also a more or less credit risk free yield curve so far the bonds issued by AHML are guaranteed by the Government. It is a real option for the mortgage loan bank if the loan portfolio can be refinanced through the AHML facilities. The problem with this curve is the lack of sufficient data for short periods (up to 1 year). Alternatively, for short periods, the bank could use MOSIBOR. If the bank is loan rich, it needs a transfer pricing yield curve that reflects the banks source and use of the funds on the whole sale market. There is no real good solution in the Russian market. Consequently the bank could use a special single curve that it derives from several benchmark yield curve. The possibilities could be the following: Rates extracted from Central bank Russia (CBR) refinancing mechanisms included intraday, overnight, and relatively short-term Lombard and Repo facilities. There are also longer-term (up to 180-day) facilities available from the CBR for which collateral is required in the form of promissory notes, rights under the loan agreements and/or bank guarantees. However, the latter loans are difficult to obtain due to the approval process and strict collateral requirements, including heavy discounts, and therefore they remain largely untested. Mosprime Moscow prime offered rate. National Foreign Exchange association began the index in April 2005. Moscow Interbank Offer Rate (MIBOR) based on 31 banks offer rates: from 2 to 7 days, from 8 to 30 days, from 31 to 90 days., from 91 to 180 days, from 181 days to 1 year, but the market for 3 months money is not liquid.

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The AHML was created by the government in 1997 in order to provide refinancing options for banks. The agency aims to finance itself mainly by issuing bonds and obligations backed by mortgages. The Russian government is the sole shareholder of the AHML and is committed to supporting the agency by providing guarantees to the AHML as well as a direct participation in the AHML equity capital.

 Yield of bonds issued by banks. The bank can choose between the rate issued by state own banks or average yield of bonds issued by banks that are the same size than the given bank. The maturity of bonds issued by banks is medium term. However the domestic ruble bond market is still relatively shallow, with the major investors being domestic banks and foreign buyers.

The following table shows the potential yield curves in the market.

For example a loan rich bank could use the following yield curves For short terms (up to 1 year), the MIBOR average. From 1 year to 5 years, the AHML For 5 years and longer, the yields from the treasury markets. II.2 Transfer Pricing Curve for USD and EUR denominated assets and liabilities Russian bank with assets or liabilities in USD and EUR currencies should use the interbank swap curve or the whole market yield curve (LIBOR). II.3. Adjustment to a base FTP yield curve There are some important adjustment that could be really useful for the banks in the Russian market too, because it would prevent inconsistent margin comparisons among products,

inaccurate measurement of the interest rate risk of the bank, and misallocation of the resources. Institution Credit Risk Adjustment: In the case of banks which are loan rich the base yield curve needs to be adjusted to reflect the banks own credit risk. The simplest solution is to define the difference between benchmark curve (especially the CBR yield curve or treasury yield curve) and the yield of the bonds that the bank issued, or the margin between the LIBOR (wholesale price) and actual price in the interbank market that the bank can borrow from. Term of Liquidity: Russian banks have to use liquidity adjustment for assets and liabilities denominated in foreign currencies. The liquidity premium can be the difference between the short term and long term floating rate fund with the same repricing period. Banks recently have lengthened funding maturities through syndications floating-interest rates borrowings. Banks are trying to mitigate refinancing risk through diversification of the investor base, both geographically and by currency, as well as through more active use of securitization. Foreign currency lending is typically long-term (more than 5 years), so the risk arises from possible maturity gaps between assets and liabilities denominated in the same currency. Additionally, as banks expand into the SME and retail segments and in the regions, where there is little demand for foreign currency loans, those banks with a large share of foreign funding may have significant on-balance-sheet currency and interest rate mismatches. Banks tend to match foreign currency assets and liabilities, with the foreign exchange risk being passed on to borrowers. For Russian banks with assets and liabilities denominated in ruble bearing fixed rates and with short deposit tenors, there is no need to apply liquidity adjustments. Bank should use the liquidity premium in the case of corporate bonds that are freely traded. These bonds have been broadly used by smaller banks, both as a source of credit exposure to and interest income from larger companies, and for liquidity management purposes. Mandatory Reserve Requirements: To reduce banks risk exposures and to manage liquidity in the banking sector, banks are required to place non-interest-bearing reserve deposits with the CBR. From 1 July 2007 the rate is 4.5 %, but only 4 % for retail deposits. Prepayment penalty: Banks having retail deposits or having retail loans should apply prepayment adjustment. These can be withdrawn on demand, incurring the penalty of foregoing earned interest; their potential flightiness has been partially mitigated, though, by the introduction of the deposit insurance system. Option Pricing Adjustment: The banks should use option pricing adjustment, where loan agreements contain a clause allowing banks to re-price customers loans, however this option is only likely to be used in an extreme scenario and would be likely to give rise to significant customer relationship issues.

The following table shows all Adjustments to the base FTP yield curve
Product s Institution Credit Risk ( loan rich bank) YES YES YES YES YES YES YES YES YES YES YES YES YES YES YES YES YES YES over 1 year weighted/ nothing over 1 year over 1 year 4% 4% 4% 4% 4,5% over 1 year over 1 year over 1 year weighted/ or nothing YES YES o YES YES Term Liquidity Adjustment to the FTP rate in RUB Prepayment Mandatory penalty reserve Interest payment or principal payment If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve If it does not fit to yield curve Funding commission

Assets Money Market assets ( treasury) Prime based Commercial loan Money Market rate indexed Commercial Fixed rate commercial loan Fixed rate mortgage loan Floating rate consumer loans Adjustable rate mortgage Prime or variable rate consumer loan. Indeterminate maturity assets Liabilities Money market dep. Retail Current account Retail deposit floating rate Retail deposit variable Retail fix rate deposit Floating corporate deposit Indeterminate maturity deposit

YES

over 1 year over 1 year

YES

III. SUMMARY FTP is a powerful tool available to management for profitability analysis and comparison among business lines, product and branches of various sizes. It allows management to make informed decision on product pricing. It helps in forecasting the individual business units performance and to measure the effectiveness of the funding centers asset and liability management. The banks need a comprehensive FTP or ALM system with appropriate IT support. There are several IT companies that provide financial institutions with sophisticated ALM software that includes transfer pricing model. Installing these models is more expensive, but fast option and gives a bank a additional know-how. We encourage banks to look into FTP. Please note, likewise any management tool. FTP should not be utilized to the exclusion of all other tools and methods of analysis and decision making.

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