FIN 6002 – Session 7

Pradeepta Sethi
TAPMI
 Funds Transfer Pricing (FTP)

• Funds surplus branches - Provider of funds - mobilize more deposits but

extend lesser amount of loan.

• Funds deficit branches -– User of funds - more potential for extending loans
and advances

• Surplus bank branches supply to the deficit branches.

• The supplier branch is compensated by way of interest payments by the

deficit branch.

• The interest at which the supplier branch is compensated is known as

transfer price.
Source : Grant, J. (2011), Liquidity transfer pricing: a guide to better practice, BIS Occasional Paper
 Funds Transfer Pricing (FTP)

¢ Traditionally, banks have viewed their branches, particularly those with

surplus deposits as the cost generators and their loan extending branches
as the profit makers.
¢ FTP is an internal allocation and measurement mechanism for determining
the pricing of incremental loans/investments/deposits and for determining the
profit contribution of various lending and borrowing units of a bank.
¢ A transfer price is an internal rate of interest used to calculate transfer
income or cost due to an internal flow of funds in a bank.
¢ It is like actual rate of interest paid or received on a bank product, since it
concerns the same transaction balance that the actual rate of interest does.
¢ The interest margin is the difference between interest rate and a transfer
price, and it allows calculating the internal interest profit on a transaction.
 Funds Transfer Pricing (FTP)

¢ Without funds transfer pricing system

l Net funds users would receive credit for interest income without being
charged for the full amount of associated interest expense.

l While net funds providers would be charged with interest expense

without being credited for the full amount of assisted interest income.

l Net funds users have the advantage because all interest income is
associated with assets and all interest expense is associated with
liabilities. So, the net users appear more profitable than the net providers.
 Transfer Pricing Mechanism

¢ This is done by the controlling office of the bank mainly under the Asset-
liability Management (ALM) system.

¢ Segregation of interest income into various segments.

¢ Transferring interest rate risk to ALM unit.

¢ Pricing funds to branches with economic benchmarks, using economic

transfer prices and other methods.

¢ ALM unit aims to maintain interest rate risk within prescribed limits while
minimizing the cost of funds or optimizing the return on investments.

¢ Transferring funds between branches.

 Systemic Risk

• Risk of a large-scale failure of a financial system

• Risk spreads from unhealthy institutions to otherwise healthy institutions

through a transmission mechanism.

• Providers of capital (depositors, investors, and capital markets) lose trust in

either the users of capital (banks, borrowers, leveraged investors, etc.), or in
a given medium of exchange (the US dollar, Japanese yen, pound sterling,
gold, etc.).

¢ Contagion - When a crisis in one financial market | one country causes a

crisis in another financial market | another country.
 CAMELS Approach

¢ Why a system of regulation & supervision? - Depositor protection and systemic

risk.
¢ 1980s - the US supervisory authorities, by the CAMEL rating system introduced
ratings for on-site examinations of banking institutions to classify a bank's overall
condition – point in time assessment.
¢ The component of bank condition that are assessed
l Capital adequacy
l Asset quality
l Management capability
l Earnings
l Liquidity
l Sensitivity (sensitivity to market risk, especially interest rate risk)
 CAMELS Approach

¢ Each of the component factors is rated on a scale of 1 (best) to 5 (worst).

¢ A composite rating is assigned as an abridgement of the component ratings and is

taken as the prime indicator of a bank’s current financial condition.

¢ The composite rating ranges between 1 (best) and 5 (worst).

¢ The CAMELS ratings are normally assessed every year.

¢ Objective of supervision - Protection of depositors’ interests and ensuring

financial health of individual banks/FIs.

¢ S. Padmanabhan committee (1995) - six rating factors - Capital Adequacy, Asset

Quality, Management, Earnings, Liquidity, Systems and Controls (i.e. CAMELS)
for Indian banks.

¢ Foreign banks, five rating factors - Capital Adequacy, Asset Quality, Liquidity,
Compliance, Systems and Controls (i.e. CALCS).
 CAMELS Approach

¢ Each of the components of CAMELS is rated on a scale of 1-100 in ascending

order of performance.

¢ The score of each CAMELS element is arrived by aggregating (by assigning

proportionate weights) the scores of various sub-parameters that constitute the
individual CAMELS parameter.

¢ Each parameter is awarded a rating A-D (A-Good, B–Satisfactory, C-

Unsatisfactory, and D-Poor).

¢ The composite “CAMELS rating” is arrived by aggregating each of the component

weights.

¢ Further the overall composite score is adjusted downwards for poor performance
in one or more components.
Rating Symbol Rating symbol indicates
A+, A, A- Good
B+, B, B- Satisfactory
C+, C, C- Unsatisfactory
D Poor
Weights of various parameters under the CAMELS/CALCS Model
CAMELS CALCS
Capital Adequacy 18 18
Asset Quality 18 18
Management 18 --
Earnings 10 --
Liquidity 18 18
Compliance -- 26
System & Control 18 20
 Limitations of CAMELS Approach

¢ It does not incorporate any forward-looking elements thereby not reflecting the
true market standing of the entity.

¢ The factors influencing the rating awarded to the bank and the implications of the
awarded rating are not shared with the banks.

¢ Moreover, it’s a stock approach (focus on the financial position of the supervised
entities at a given point in time).

¢ Chakrabarty committee (2012) – Risk based supervision

Banking stability map and indicator

Source:Mishra R.N., Majumdar, S. and Bhandia, D (2013). Banking Stability - A Precursor to Financial Stability, RBI WPS (DEPR)