Journal of Performance Management: Best Practices & Strategic Value of Funds Transfer Pricing

Journal of
Performance
Management
Best Practices & Strategic Value of Funds

Transfer Pricing
- ORLANDO B. HANSELMAN -
Funds Transfer Pricing:

A Management Accounting Approach within the Banking Industry
- JENNIFER D. RICE -
- MEHMET C. KOCAKULAH -
Transfer Pricing Capital

- ALEXANDER KIPKALOV -
To FTP Or Not To FTP - That Is The Question!

- W.RANDALL PAYANT, CRP -
Volume 22, Number 2

The Journal of Performance Management seeks articles from management information
professionals on subjects related to management information in the financial servides
industry.
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All articles in the Journal reflect the views of the authors and should not be construed
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AMIfs Research Committee

Jeff Nathasingh, BBVA Compass, Chair
Greg Fitzgerald, AmTrust
William Di Filippo, Frost Bank
Chris Rebant, Huntington
The Research Committee can be contacted by email at Research@amifs.org
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Table of Contents
Prologue.......................................................................................................... 2

Transfer Pricing .............................................................................................. 3
- ORLANDO B. HANSELMAN -
Funds Transfer Pricing:

A Management Accounting Approach within the Banking Industry ........ 17
- JENNIFER D. RICE -
- MEHMET C. KOCAKULAH -
Transfer Pricing Capital .............................................................................. 27

- ALEXANDER KIPKALOV -
To FTP Or Not To FTP - That Is The Question! ........................................ 33

- W. RANDALL PAYANT, CRP -
ASSOCIATION FOR
MANAGEMENT INFORMATION
IN FINANCIAL SERVICES
TABLE OF CONTENTS 1
Prologue
THE ORGANIZATION
The Association for Management Information in Financial Services (AMIfs) is the preeminent organi-
zation for management information professionals in the financial services industry. Founded in 1980
(known then as NABCA), AMIfs has become the premier organization of its type, and counts among
its members individuals who set the policies and advance the concepts of management information at
major financial institutions worldwide.
ASSOCIATION MISSION
AMIfs is a not-for-profit professional association dedicated to developing and advancing the profession
of management information for the financial services industry. Its goals are:
n Leadership: Develop opportunities for members to advance the

profession by participating in the Association.
n Research: Identify and coordinate research activities that support

the goals of the organization and advance the profession.
n Education & Training: Provide professional development

opportunities for industry practitioners.
n Networking: Provide opportunities for members to interact and

share experience, knowledge, and insights.
n Other Member Services: Provide related services that add value

to membership.
n Infrastructure: Establish and maintain an organizational structure

designed to accomplish the Association’s mission through ongoing
involvement of industry professionals.
JOURNAL OF PERFORMANCE MANAGEMENT 2

Best Practices Transfer PricingValue of Funds
& Strategic
Transfer Pricing
Orlando B. Hanselman
Education Programs Director
Risk & Performance Solutions
Fiserv
orlando.hanselman@fiserv.com
About the Author:

Described by clients as a “dynamic profitability and performance management speaker”,
Orlando B. Hanselman teaches and consults with financial institution executive and
board teams throughout the world. In all areas of strategic planning, optimization of risk
and profitability performance, asset/liability management, economic capital and funds
transfer pricing, Orlando provides clients with an ability to understand easily and apply
effectively tactics to improve risk-adjusted returns. Clients acclaim Orlando’s “straight
forward practical solutions” and “strategic orientation”, emphasizing that his “combination
of knowledge and enthusiasm are second to none.” Recognizing “great results”, clients
tout Orlando’s “expertise”, “creativity” and “integrity”. The Education Programs Director
for The Institute at Fiserv Risk and Performance Solutions, Orlando may be reached at
orlando.hanselman@fiserv.com.
Executive Summary: Do you know where your profits come from? Do you know
which products or customers create value for the financial institution (“FSI”) and
which destroy it? Sadly, most FSI today do not have the measured answers to these
questions. And too often the intuitive answers are at best misleading or frequently
wrong. Currently most FSI simply price loans and deposits to mimic their
competitors, who generally have different strategies, goals, risk tolerances and cost
structures. Increasingly, however, high performance FSI wishing to create a winning
competitive advantage use matched-term funds transfer pricing (“FTP”). These high
performance financial institutions use FTP’s insights to create strategic value and
optimize net interest margins. This article discusses the basics of matched-term
funds transfer pricing. Current FTP best practices used by FSI world-wide,
introductory insights into FTP’s strategic value and tips for getting started are also
covered.
Financial institutions (“FSI”) eagerly seeking a competitive advantage understand and
pursue the substantial strategic benefits derived from best practice matched-term funds
BEST PRACTIVES & STRATEGIC VALUE OF FUNDS TRANSFER PRICING 3

1
transfer pricing (“FTP”) at the instrument level. Matched-term FTP is widely embraced
by high performing FSI that recognize it as a critical path to enlightened risk and return
net interest margin analytics as well as key to optimize margin performance. These high
performance FSI comprehend the truth that you cannot effectively manage without
measured insights.
Roles and Strategic Benefits
Funds transfer pricing is an internal management information system and methodology
designed to allocate the net interest margin between funds users, such as lenders and
investment officers, and funds providers, including branch deposit gathers and the
treasury function. Equally true and more pragmatic is the definition of FTP as a rigorous
measurement and pricing method based upon the pretense that all funds are bought and
sold in an open market. Best practices matched-term FTP establishes a framework for
this net interest margin allocation process by incorporating this market pretense concept.
Since FTP fosters improved understanding and valuable strategic insights related to the
single largest contributor of a FSI’s financial performance, the net interest margin, its
importance cannot be over emphasized. Increasingly FSI executives acknowledge FTP
as the most essential component of a well developed and comprehensive profitability
measurement system. Matched-term FTP is the only path to measuring, understanding
and effectively managing customer profitability. Simply put, a FSI cannot measure
customer profitability without a sound and proven net interest margin allocation
methodology as provided by instrument level matched-term FTP.
A best practice FTP system is both a risk and return analytical tool. With a well
designed FTP system, a FSI will be able to:
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JOURNAL OF PERFORMANCE MANAGEMENT
 Measure business unit, product and customer profitability.
 Measure and segregate net interest margin risk components.
 Achieve improved net interest margin accountability and segregation of duties.
 Develop a sound basis for optimal customized loan and deposit pricing.
 Institute improved risk-based product pricing with higher net interest spreads.
Highly successful executives have always understood the fundamental management
truths that you cannot manage something if you do not measure it and if everyone is
accountable for an important performance factor no one is accountable. Matched-term
FTP adheres to these fundamental management truths.
The Basics
Financial instrument by financial instrument, each source of funds, such as a deposit or
borrowing, and each use of funds, such as a loan or investment, are valued at the time
of their origination. This valuation is accomplished by assigning each financial
instrument an associated transfer rate from an appropriate transfer curve(s). The
associated transfer rate mirrors as closely as possible the underlying financial
instrument’s cash flows, repricing and optionality attributes. This assigned transfer rate
is then wed to the financial instrument and does not change until the financial instrument
either matures or reprices. The allocation of the FSI’s net interest margin is
accomplished by this instrument by instrument valuation. With this instrument level
processing, the FSI effectively aggregates FTP results at the total organizational level as
well as at the business unit, product and customer levels.
Assigned transfer rates must match the financial instrument as closely as possible.
Cash flow, repricing and maturity of the instrument will be used to determine the

3
appropriate point on the transfer curve(s) to find the transfer rate. While indeterminate
maturity financial instruments such as credit cards, open lines of credit and checking
accounts pose an additional challenge, several best practice methods for effectively
estimating their maturity have emerged and become well accepted within the industry. If
the underlying financial instrument has a fixed rate, the transfer rate should be a fixed
rate. Adjustable rate financial instruments should have a transfer rate which changes
upon the instrument’s reset date. Floating rate instruments should have a floating
transfer rate. Financial instruments that amortize should have a transfer rate that
considers amortization. And finally, if the underlying financial instrument allows for
prepayments or early withdrawals, the transfer rate should do the same.
In selecting transfer curve(s) some FSI use one curve for all assets and liabilities, while
others prefer multiple curves dependent upon the specific nature of their different assets
and liabilities. FSI opting for one curve for the entire balance sheet generally assess
their tendency to be either asset or liability heavy and select the curve to correspond to
their positioning. Using more than one curve may introduce an element of basis risk due
to the possibility of fluctuations in the spread between either the asset or the liability
transfer curves. This concern is largely mitigated since the process of matched-term
FTP effectively isolates interest rate risk, including such created basis risk, to the
centralized funding center. It is the funding center which earns a mismatch spread as a
return for responsible management of the FSI’s aggregate interest rate risk. Acceptable
market-driven curve choices include those associated with government investments and
bonds, LIBOR, advance borrowings offered by governments and their agencies,
SWAPS, commercial paper and brokered deposits. Some FSI even construct a curve
based upon a combination of these choices such as use of an overnight government
6
4
rate at the shortest end, commercial paper for the intermediate term and government
advances for the long-term.
No one “right” answer has yet emerged as best practice in choosing a FSI’s fund transfer
pricing curve(s). Each option presented has both strengths and weaknesses. Intelligent
selection of funds transfer price curve(s) must, however, encompass our agreed-upon
FTP market pretense definition as well as embrace certain critical characteristics related
to optimal curve(s) choice. Four critical curve(s) characteristics are generally accepted:
1. Curve(s) should represent the opportunity cost or benefit of the funds.
2. Curve(s) should represent marginal wholesale rates.
3. Curve(s) should be derived from reliable and readily available data
sources.
4. Curve(s) should be credible as well as understood by and acceptable to
FTP users such as lenders, investment officers, liquidity managers,
branch deposit gatherers and treasury personnel.
Many FSI, based upon this conceptually sound thought process, utilize two curves best
tailored to their unique business model of incremental funds deployment and
procurement: a market-based alternative investment curve for deposits and borrowings
and a market-based alternative liquidity funding source curve for loans and investments.
This curve decision is sound in definition and characteristics, practical and realistic in
design and allows simple execution for the entire balance sheet.
To ensure the transfer rate best mirrors the cash flow of the underlying financial
instrument, FSI generally use a strip funded methodology (FIGURE 1). Each principal
cash flow, unadjusted for prepayment or early withdrawal, is valued separately on the
transfer curve to arrive at a blended transfer rate. For example, a six year $20,000

5
amortizing loan with an 8.0% interest rate would be wed to a blended transfer rate of
4.9%, representing a composite of six different points on the transfer curve at loan
origination, each point reflecting the annual principal repayment cash flows. Using this
strip funded methodology provides a better matched transfer rate more closely mirroring
the financial instrument’s cash flows, giving full consideration of the yield curve shape of
the market-based transfer curve. Accordingly, the strip funded methodology best
captures both the cash flow as well as the economic market reality at loan origination.
The matched-term FTP method is performed financial instrument by financial instrument
at the time of the instrument’s origination. The net interest margin is allocated by
assigning notional transfer rates to all fund sources and uses. This process determines
transfer expense related to assets such as loans or investments and transfer income
amortizing loan with an 8.0% interest rate would be wed to a blended transfer rate of
related to funding liabilities such as deposits and borrowings. Only through this process
4.9%, representing a composite of six different points on the transfer curve at loan
is the well understood and accepted economic value of customer deposits and FSI
origination, each point reflecting the annual principal repayment cash flows. Using this
branches measured and recognized.
strip funded methodology provides a better matched transfer rate more closely mirroring
the financial instrument’s cash flows, giving full consideration of the yield curve shape of
Generally speaking, when a loan is originated the transfer rate is established by locating
the market-based transfer curve. Accordingly, the strip funded methodology best
on the selected transfer curve the corresponding term point, or points in the case of the
Figure
captures both the cash flow as well as the 1 market reality at loan origination.
economic
recommended strip funded approach. This matched transfer rate or blended transfer
rate derived from the curve is then wed to the underlying financial instrument. Our
The matched-term FTP method is performed financial instrument by financial instrument
FIGURE 2 example shows a one year loan with a rate charged to the customer of 7.25%
at the time of the instrument’s origination. The net interest margin is allocated by
wed to a 5.25% transfer expense rate, representing the market-based incremental
assigning notional transfer rates to all fund sources and uses. This process determines
funding cost. This 2.00% difference between the rate negotiated with and paid by the
transfer expense related to assets such as loans or investments and transfer income
borrower and the transfer rate is the credit spread. Credit spread is earned by the
related to funding liabilities such as deposits and borrowings. Only through this process
lenders for assuming credit risk and it must be adequate to compensate for: credit
is the well understood and accepted economic value of customer deposits and FSI
losses; direct operating costs related to the lending operations and loan servicing; and
6 8
on the selected transfer curve the corresponding term point, or points in the case of the
recommended strip funded approach. This matched transfer rate or blended transfer
rate derived from the curve is then wed to the underlying financial instrument. Our
FIGURE 2 example shows a one year loan with a rate charged to the customer of 7.25%
wed to a 5.25% transfer expense rate, representing the market-based incremental
funding cost. This 2.00% difference between the rate negotiated with and paid by the
borrower and the transfer rate is the credit spread. Credit spread is earned by the
lenders for assuming credit risk and it must be adequate to compensate for: credit
losses; direct operating costs related to the lending operations and loan servicing; and
general allocated FSI overhead. This net credit spread must also generate an adequate
6
profitability return.
Likewise, for a deposit account the appropriate point on the selected transfer curve is
located to match the underlying financial instrument. Our FIGURE 2 example shows a 3
month 3.25% customer certificate of deposit matched to a transfer income rate of 4.25%,
representing the market-based incremental value of the funds provided. This 1.00%
difference between the transfer income rate and the deposit rate paid to the customer is
known as the deposit franchise spread. The deposit franchise spread is earned by the
branch for cost effectively obtaining retail funding for the FSI. This deposit franchise
spread must be adequate to compensate for direct operating costs of the branch and
retail delivery systems as well as general allocated credit FSI overhead. This net
deposit spread must also generate an adequate profitability return.
Figure 2
After every financial instrument has been valued one by one through the FTP system,
the remaining difference between all transfer rates is known as the mismatch spread.
Our FIGURE 2 example shows a mismatch spread of 1.00%. This mismatch spread is
earned by the FSI’s funding center. It is the funding center, created as a business unit
during implementation of the FTP process, which manages holistically the aggregate
profitability return.
Likewise, for a deposit account the appropriate point on the selected transfer curve is
located to match the underlying financial instrument. Our FIGURE 2 example shows a 3
month 3.25% customer certificate of deposit matched to a transfer income rate of 4.25%,
representing the market-based incremental value of the funds provided. This 1.00%
difference between the transfer income rate and the deposit rate paid to the customer is
known as the deposit franchise spread. The deposit franchise spread is earned by the
branch for cost effectively obtaining retail funding for the FSI. This deposit franchise
spread must be adequate to compensate for direct operating costs of the branch and
retail delivery systems as well as general allocated credit FSI overhead. This net
deposit spread must also generate an adequate profitability return.
After every financial instrument has been valued one by one through the FTP system,
the remaining difference between all transfer rates is known as the mismatch spread.
Our FIGURE 2 example shows a mismatch spread of 1.00%. This mismatch spread is
earned by the FSI’s funding center. It is the funding center, created as a business unit
during implementation of the FTP process, which manages holistically the aggregate
interest rate and market risk of the FSI. The mismatch spread compensates the funding
center for assuming responsibility for mismatch risk management and must be adequate
to cover: direct operating costs of the funding center; general allocated FSI overhead;
and hedging or other costs of mismatch risk protection. It must also produce an
adequate profitability return.
Some FSI elect to make other adjustments to the derived transfer rates including:
 early withdrawal penalties, reserve requirements

7 and insurance premiums for
deposits.
 prepayment penalties, collateral costs and liquidity premiums for loans.
Using special product promotions, FSI more effectively reach growth and balance goals
by adjusting derived transfer rates to further incent desired business unit and employee
behaviors. The FSI’s need to rebalance risk exposures, such as lending concentrations,
 early withdrawal penalties, reserve requirements and insurance premiums for
deposits.
 prepayment penalties, collateral costs and liquidity premiums for loans.
Using special product promotions, FSI more effectively reach growth and balance goals
by adjusting derived transfer rates to further incent desired business unit and employee
behaviors. The FSI’s need to rebalance risk exposures, such as lending concentrations,
may also be facilitated by temporary transfer rate adjustments. FSI choose to make
these elective adjustments based upon their unique strategies, goals and risk tolerances
as well as the materiality to the net interest margin of the factors being considered.
It is in this manner, financial instrument by financial instrument, that matched-term FTP
allocates the net interest margin contribution and establishes improved net interest
margin accountability. While every FSI measures and reports their total net interest
margin, only those using FTP are able to explain and quantify these three sources of net
interest margin contribution: credit spread; deposit franchise spread; and mismatch
spread. Improved margin accountability is achieved because we now have three
discrete management buckets, each containing segregated risk, return and
responsibility. The lender bucket holds assumed credit risk with resulting credit spread
return and establishes exclusive lender accountability for managing the FSI’s credit risk.
The branch bucket holds assumed liquidity risk with the resulting deposit franchise
spread return and establishes exclusive branch responsibility for cost effectively
obtaining the appropriate amounts of retail funding just in time as needed. And finally,
the funding center bucket holds assumed interest and market risk with the resulting
mismatch spread return and establishes exclusive responsibility for macro-management
of the FSI’s interest and market risk. These three buckets provide the FSI with
heightened accountability and enhanced segregation of duties.

As a result of this process, the FSI has now achieved the first critical step in measuring
its business unit, product and customer profitability, an allocated net interest margin.
Bear in mind, without FTP, a typical branch’s income statement is primarily comprised of
fee income, deposit expense, overhead expenses and some direct loan income. The
major source of a branch’s economic contribution to the FSI, which is only measured
with FTP, is the deposit franchise spread earned on its generated deposits. Likewise, a
lending unit’s income statement without FTP is primarily comprised of loan income,
credit losses and overhead. Without FTP lending units are not assessed a cost of
funding for the loans they make, much akin to selling cars without paying for the steel
used in manufacturing. It is only through use of an FTP system that business unit
profitability can be properly measured and thereafter appropriately managed. Once
each financial instrument has an associated transfer cost or value, product and customer
profitability becomes the aggregation of all allocated net interest margin dollars
associated with the applicable underlying instruments.
Sound Starting Point for Pricing
Each FSI may now use these well grounded FTP insights to provide optimal customized
loan and deposit pricing. Such optimal pricing begins with the FTP derived cost of funds
used or value of funds provided plus consideration of the following elements:
 Costs of business operations.
 Goals and strategies.
 Imbedded transaction risks.
These elements are specific to each FSI and should not be ignored when establishing
prices.
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9
Our optimal customized loan price would be determined by this formula:
FTP cost of funds used
+ Fixed and variable lifetime costs associated with the loan
+ Cost of assigned capital based upon all imbedded risks (credit,
interest rate, market, liquidity and operational) related to the loan
as well as specific to the customer
+ Strategic return expected
For deposits, the formula for optimal customized pricing would be:
FTP value of funds provided
- Fixed and variable lifetime costs associated with the deposit
- Cost of assigned capital based upon all imbedded risks (interest
rate, market, liquidity and operational) related to the deposit
- Strategic return expected
These FTP based formulae determine a FSI’s unique and optimal price which provides
an economic risk-adjusted profit as well as book profit at the strategic return rate
expected. From this suggested optimal price, further tailored pricing refinements may be
considered such as the customer’s loyalty and price elasticity as well as specific value-
added product features. The local competitive market as well as the FSI’s balance sheet
needs and risk positioning must also be considered prior to finalizing the price.
Getting Started
Some FSI have failed to pursue the significant strategic value offered by FTP because of
their lack of knowledge, concerns related to cost and time involved and a mistaken belief
that their current measurements are adequate. Shrinking industry net interest margins
are accenting the need for FTP. Falling PC-based FTP technology costs are expanding
the affordability and scalability of this proven solution. These market factors, coupled

10
with high performing FSI’s demonstrated FTP success and heightened regulatory
demand for better risk-based pricing, resoundingly rebut the rationality of this inaction.
Reasonable implementation time is required, however, and like any worthwhile journey it
begins with the first step. Four key steps guide this profitable strategic journey:
1. Educate and involve key FSI personnel. While the Chief Financial Officer
and the accounting staff are most likely going to lead this journey, it is
critical to ultimate success that executive officers and lenders as well as
branch, investment, treasury and marketing personnel be actively
involved and that they collectively reach a level of comfort and
understanding. The return on your FTP investment comes from
optimizing the net interest margin with enhanced accountability and
pricing sophistication based upon daily effective use and understanding
by lenders and branch, treasury and investment personnel.
2. Form a project steering committee including finance and accounting staff
as well as key end users. The steering committee is essential to ensure
FTP understanding and acceptance, adept project management,
involvement, thorough communication and timely implementation. The
appointed committee chair should be knowledgeable, respected and
unbiased. It is the chair who must freely facilitate discussion to reach
accepted consensus on FTP’s many choices and assumptions. When
consensus cannot be reached in a reasonable timeframe, however, the
chair must have the authority and grit to end further fruitless discussion
and pronounce a binding decision.
3. Review vendor FTP systems and PC-based models. Your steering
committee should select a vendor who provides you with a robust and
flexible tool and, most critically, exceptional implementation and post-
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implementation technical support. The software model should
accommodate a vast variety of rate adjustments as well as complex
financial instrument cash flows. Ideally your FTP model should also
promote integrated data and insight sharing between your other
profitability measurement, budgeting, risk analytics and performance
management software. Vendors must also possess a strong client base
and a history of long-term financial industry software leadership.
Independent and leading edge education aimed at understanding and
utilizing system reports, incorporating data insights into sound winning
strategy, and earning an acceptable return on your software investment
(“ROI”) is mission critical. Avoid vendors who do not offer this education.
4. Collaborate with your chosen vendor to:
a. Decide on the rationale and source of transfer curve(s)
b. Gather data and implement a customized FTP system tailored to
your strategies, philosophies and goals.
c. Produce, analyze and adjust preliminary results. Remember that
this will be an evolutionary process of continuous improvement
and refinement. Initial reports will require refinements and
adjustments.
An educated and involved steering committee is essential for success of the project and
realization of the ROI. The steering committee should be involved from the very outset
until credible reports are being consistently produced and used by line personnel. It is
the responsibility of the steering committee to ensure that personnel understand and
participate in system design to ensure buy-in. The steering committee must also keep
the project progressing, avoiding a costly search for elusive and unnecessary
“precision”. The goal is to produce a fair and realistic assessment of the net interest

12
margin contribution as well as credible results for users. Finally, the steering committee
must actively employ education and communication to overcome imbedded cultural
barriers. Overcoming such barriers is essential to embracing FTP and unlocking its
strategic value and ROI.
Conclusion
The world-wide consensus is that best practice FTP requires assignment of a market-
based contribution value to funds provided and used determined by assessment of each
individual financial instrument at the time of origination. It is also essential that your FTP
system is understandable, explainable, consistent, well documented and credible with
users. Your FTP system must be customized to your unique FSI. High performance FSI
wishing to create a winning competitive advantage use FTP’s insights to create strategic
value and optimize net interest margins. They recognize that FTP is a critical path to
enlightened risk and return net interest margin analytics and is key to optimizing the
margin. Begin your profitable journey on this proven path today.
(This article originally appeared as “Intelligent by Design: Selecting Funds

Transfer Pricing Curves to Optimize Margins” as the cover in the April 2008 Bank
Asset/Liability Management issue. In May 2008 CUES FYI published a two part
serial as “What’s the Right Transfer Rate” and “Getting Started with FTP”. The
third part of the serial was later published in the June 2008 Credit Union Magazine
as “Funds Transfer Pricing”.)
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Funds Transfer Pricing: A Management Accounting Approach
within the Banking Industry *
Funds Transfer Pricing: A Management Accounting Approach within the
Banking Industry
Jennifer D. Rice,
Old National Bancorp
jennifer_rice@oldnational.com
Mehmet C. Kocakulah*
Department of Accounting and Business Law
School of Business
University of Southern Indiana,
Mkocakul@usi.edu
Introduction
Funds Transfer Pricing is a management accounting tool used within the banking industry
that can be used to improve profitability. Through Funds Transfer Pricing (FTP), a bank can
better analyze its net interest margin1, which typically serves as the traditional banks’ largest
source of profitability2 (Kimball, 97). Funds transfer pricing provides management with a means
of crediting both funds-using and funds-generating business lines with the entire net interest
margin. The FTP rates used within a given bank reflects’ their cost of funding as an institution.
When utilizing FTP within a bank, FTP rates are assigned to all earning assets to reflect
the true cost of funding. FTP credits are applied to all interest-bearing liabilities to reflect the
benefit to the bank for the collection of funds. For both earning assets and interest-bearing
1
Net Interest Margin is defined as net interest income (interest income less interest expense), on a tax equivalent
basis, expressed as a percentage of average earning assets.
FUNDS TRANSFER PRICING: A MANAGEMENT ACCOUNTING APPROACH WITHIN THE BANKING INDUSTRY 17
liabilities, a profitability spread is calculated in order to analyze the contribution the balance
sheet item has made to the net interest margin. For earning assets, the profitability spread is
calculated as the yield (from interest income) less the FTP charge. For interest-bearing
liabilities, the profitability spread is calculated as the FTP credit (for the collection of funds) less
the yield (from interest expense). The FTP rates applied to each account reflect the rates for
wholesale investment/borrowing alternatives for the institution. Within this study, we will
provide an overview of FTP fundamentals and describe how financial institutions can use these
techniques to improve their profitability.
Overview of Funds Transfer Pricing
With FTP, each customer account is assigned a rate that is based upon the structure of the
product. For example, the following items all impact the calculation of the FTP rate: term
structure, repricing characteristics (fixed or floating rate), payment structure, and interest rates at
the time of the origination or rate change date. For loans, the longer the term of the account and
the less frequent that the rate paid from the customer changes, the higher the cost of funds
incurred by the bank under a normal yield curve. For example, a fifteen year fixed rate mortgage
at origination has a higher cost of funds to a bank than a floating rate home equity loan with a
five-year maturity. In order to fund these loans, the bank would have to borrow the money to
fund each loan for fifteen years and five years, respectively. Because the cost of borrowing these
funds is greater for the fifteen-year loan, the FTP rate charges reflect this cost to the bank.
For deposits, the longer the term of the account, the greater the FTP credit applied to the
account under a normal yield curve. For example, a five-year certificate of deposit provides
longer term funding for the bank to use to fund loans and has greater value than does a one-year
2
According to R. Kimball in the New England Economic Review, net interest margin ranges between 60 to 80
percent of bank revenue.
JOURNAL OF PERFORMANCE MANAGEMENT 2 18

certificate of deposit. In the case of the five-year certificate of deposit, the account would
receive an FTP credit equivalent to the five-year rate on the banks’ funding curve. This FTP rate
would reflect the cost of the bank borrowing the funds for five years on the wholesale market3 at
the time the deposit was originated. It is important for banks’ to encourage their employees to
collect deposits, because when priced effectively, they are a much cheaper source of funding
loans.
In order to provide value, banks’ must create a well defined and sophisticated funds
transfer pricing system. “A funds transfer pricing process that assigns a market-based
contribution value to each source and use of funds, based on the underlying account or
transaction attributes at the time of origin, is the most comprehensive method for inclusion in an
overall profitability measurement process (AMIfs Research Committee,2001).” Software
programs can be purchased to aid in the assignment of funds transfer pricing. The most
sophisticated method of assigning FTP rates is matched-term funding in which unique FTP rates
are assigned to each source and use of funds at the time of origination and each subsequent
scheduled rate change.
When implementing a FTP system, banks’ must determine a “funding curve” that most
reflects their source or use of funds on the wholesale market. Some banks may utilize an inter-
bank rate such as LIBOR (London Inter-Bank Offer Rate)/SWAP rates or a common rate index
such as United States Treasuries. The funding curve, “simply plots the relationship between time
to maturity and yield to maturity for a given type of financial instrument (Hogan Systems Inc.,
2000).” An example of a funding curve is show below in Exhibit 1.
3
Typical sources of wholesale funding include federal funds, Federal Home Loan Bank (FHLB) borrowings,
brokered certificate of deposits, and borrowings from other financial institutions.
FUNDS TRANSFER PRICING: A MANAGEMENT ACCOUNTING APPROACH WITHIN THE BANKING INDUSTRY
3 19
Exhibit #1
SWAP Rates as of March 15, 2002
7.00%
6.00%
5.00%
4.00%
Rate
3.00% 3/15/2002
2.00%
1.00%
0.00%
R
ap
ap
ap
ap
ap
ap
O
w
B
rS
rS
LI
ar
ar
ar
ar
ea
ea
th
ye
ye
ye
ye
on
-y
-y
2-
3-
5-
7-
10
15
M
12
Maturity
Often, adjustments are made to the base-funding curve to reflect a customized curve for
an individual institution. Also, adjustments are made to reflect the banks’ financial condition
and its industry ratings, thus impacting how closely the institution can borrow funds at the
market costs on the base curve. Common adjustments to the base-funding curve include
liquidity (i.e., how easily the account can be converted into a more liquid investment)
adjustments and option pricing adjustments (i.e., because customers have the right to pay off
their loan or redeem their deposit at no charge before the contractual maturity date).
Banks must decide how often funds transfer pricing rates should be assigned. The
frequency of FTP rate application is often determined based upon the limitations within a bank
when collecting their data. FTP rates may be updated as frequently as real time, daily, weekly,
or monthly.
Before implementing a funds transfer pricing system within a bank, management must be
educated on the processes and “buy in” on the benefits of the internal management system. In
addition, all employees must be educated on the functionality of the system. They must also be
educated on how to use FTP when making their pricing decisions.

Using Funds Transfer Pricing to Improve Profitability
Banks utilize funds transfer pricing to improve their pricing decisions and overall
profitability. FTP can be used as a means of accountability for all lines of businesses within a
bank. In addition, funds transfer pricing can be used to hold employees accountable for their
pricing decisions because an individualized FTP rate is applied at the transaction account level.
FTP is used to “identify, measure, monitor, and create management accountability for the
components of net interest margin based on the inherent value and risks associated with the
gathering and eventual use of funds in the financial intermediation process (AMIfs Research
Committee, 2001).”
An alternative approach to funds transfer pricing is managing a banks’ net interest margin
strictly through the “all in yield” paid to or received from the customer. However, focusing on
the yield and not the costs of funding the products is the same as a sales manager focusing solely
on revenues and not the expenses associated with his or her sales. Banks’ must take into
consideration their costs of funds’ in order to control their net interest margin and ultimately
their net profit. In addition, banks’ that focus strictly on yields are not managing their interest
rate risk. Interest rate risk is created because of the different characteristics (i.e. rate change
frequency, terms, etc.) of the sources (deposits and wholesale funds) and uses (loans and
investments) of funds within their institution.
Funds transfer pricing enables banks’ to prepare profitability analyses, specifically for
their net interest margin, for each of their business lines. FTP measures profitability down to the
individual product and customer level (Coffey, 2001). Funds transfer pricing provides
management with valuable information that will aid them in making sound business decisions
with the goal of increasing net income and shareholders’ return. FTP can be used as a
5 21
foundation to quantify the profitability of an entire customer relationship (i.e. loans, deposits,
and other banking services).
When a funds transfer pricing system is implemented effectively within a bank, the
institution can break down their net interest margin contribution into loan contribution, deposit
contribution, and interest rate risk. The following example illustrates how FTP aids banks’ in the
analysis of their profitability.
Average Yield on Loans* 8.0%
Cost of Deposits** 5.0%
Net Interest Margin 3.0%
*Average life of 8 Years; Cost of funding was 7%
**Average life of 2 Years; Cost of funding was 6%
Average Yield on Loans 8.0% Average Cost of Funds 6.0%
Average Cost of Funds 7.0% Average Yield on Deposits 5.0%
Average Spread to FTP 1.0% Average Spread to FTP 1.0%
The 3% net interest margin is composed of 1% net interest margin on loans (8% less 7%), 1%
net interest margin on deposits (6% less 5%), and 1% net interest margin on interest rate
mismatch (7% less 6%). The income from the interest rate mismatch is generated because of the
difference between funding loans with eight-year average lives by deposits with two- year
average lives. Although this interest rate mismatch has created additional earnings for this
institution, excess amounts often create unwanted risks. In order to better manage the interest
rate mismatch, banks’ typically create a business unit that is responsible for monitoring and

managing the interest rate risk. Banks’ do not have the ability to easily eliminate their interest
rate risk mismatch in its entirety.
When funds transfer pricing is implemented within a bank, it is critical that adequate
management reports are created and distributed within the institution. Often institutions only
provide reports to top management at a very high level of detail. It is important to provide
management with reports that are useful for their future decision-making processes. Exhibit #2
illustrates how banks’ can compare their different operating units for new production on loans.
The graph depicts the spread to FTP (yield paid to bank less the cost of funding the loan) on all
new loans booked over the past three months. Executive management can use this information
to analyze what caused the decline in spread for Region #1 and Region #3 during the month of
March 2002. This information should be used to prevent the decline in spread for future months.
Exhibit #2
Total Loans-Monthly Production
3.60
Weighted Average
3.40
3.20
Spread (%)
3.00 Region #1
2.80 Region #2
2.60
Region #3
2.40
2.20
Jan-02 Feb-02 Mar-02
Month
In order to improve net interest income within a bank, senior management can hold their
individual employees accountable for their funding spreads. Bank employees can be given the
ability to review the profitability of all accounts that they originate. An example of a detailed
report is found in Exhibit 3.
Funds Transfer Pricing - Certificates of Deposit

Exhibit #3
7 23
Officer Account Origin Maturity
Code Branch Number Balance Yield FTP Spread Date Date
7 7 412 10,000 5.59% 7.58% 1.99% 6/10/2000 6/10/2003
7 5 443 881 5.49% 7.42% 1.93% 7/19/2000 7/19/2002
6 7 517 10,000 3.60% 3.69% 0.09% 9/1/2001 9/1/2002
2 1 522 10,000 5.00% 7.05% 2.05% 9/7/1999 9/7/2004
4 4 1406 15,000 5.40% 7.80% 2.40% 5/30/2000 5/30/2003
1 4 1446 15,302 5.49% 7.30% 1.81% 8/12/2000 8/12/2002
5 4 1540 10,000 5.00% 7.05% 2.05% 9/21/1999 9/21/2004
4 14 1574 45,000 4.91% 5.77% 0.86% 2/1/2001 5/1/2002
10 4 1595 10,000 4.52% 5.38% 0.86% 3/1/2001 6/1/2002
4 4 1599 45,000 4.52% 5.38% 0.86% 3/2/2001 6/2/2002
It is important to note that the information provided within Exhibit 3 includes the officer code of
the employee who booked the certificate of deposit. The profitability of the certificate of
deposits shown in this exhibit range from a spread of 0.86% to 2.40%.
Banks’ may chose to link their incentive programs to their spreads to FTP. For example,
a customer service representative may be offered a monetary incentive to originate a certificate
that exceeds their targets for the year. According to Randall T. Kawano, “unless the system
motivates profitable actions and provides for comparable performance evaluation – two major
objectives of transfer pricing – there may be little to no benefit realized in terms of earnings
enhancement (Kawano, 2000).” However, before integrating FTP within incentive programs, a
bank must ensure they have carefully created effective programs that will not promote behavior
that is not in the best interest of the bank as a whole.
Funds transfer pricing serves as the first step in analyzing profitability within a financial
institution. According to Ralph Kimball, “while funds transfer pricing systems were a great step
forward, both in disaggregating the net interest margin and in identifying and managing bank
exposure to interest rate risk, they are not sufficient in and of themselves to calculate
organizational profitability (Kimball, 97).” Activity-based-costing (ABC) serves as an excellent
addition to the funds transfer pricing methodology. ABC aids banks’ in better understanding the

business process and the activities that constitute it. For example, when a loan is originated and
funded, the cost of funding the loan is not the only cost incurred by the bank. The bank must
process the loan application, prepare loan documentation, mail documents, and pay salaries to all
employees involved in the loan preparation process.
Using Funds Transfer Pricing for Budgeting and Planning
Banks can improve their planning processes by integrating funds transfer pricing into
their methods. Not only does this reinforce the importance of FTP within an institution, it also
eliminates the banks requirement to estimate future interest rates. A banks’ treasury department
typically holds the responsibility for forecasting future interest rates and economic condition.
Each year, banks’ prepare an annual budget that estimates net interest margin by profit and cost
center. When senior management meets with their divisions concerning the budget, they will
discuss their expectations of volumes and profitability. Rather than quantifying the yields that
will be received on new loan production or paid on interest bearing deposits, the divisions should
plan their “spread to FTP” for their new business production. Because they will be planning a
profit spread and not an all in rate, they should be able to make better decisions and meet budget
in a changing interest rate environment. It is important for budget variance analyses to be
completed monthly in order to provide adequate information for decision-making purposes.
Summary/Conclusion
Funds transfer pricing is a very important management accounting tool used within the
banking industry because it helps banks’ make profitable decisions. FTP provides a quantitative
means to measure customer profitability and should be used in the performance evaluations of
9 25
business units. When implemented and used effectively, FTP will help increase a banks’ ability
to monitor and improve its net interest margin. Bank employees’ can be rewarded for collecting
customer deposits that are less expensive than the banks’ wholesale funding costs. In addition,
loan officers can be rewarded for originating profitable loans, those that have a positive spread to
the banks’ cost of funds. Ultimately, management and employees must be well educated and
accepting of funds transfer pricing in order for it to be successful within an institution.
References
AMIfs Research Committee, “Assignment of Contribution for Funds Transferred Internally,”

Journal of Bank Cost & Management Accounting, 2001, Volume 14, Number 3.
Coffey, John J., “What is fund transfer pricing?” Bank Marketing, November 2001, Volume 33,
Issue 9.
Hogan Systems, Inc. with contributions from Cole T. Whitney and Woody Alexander, “Funds
Transfer Pricing: A Perspective on Policies and Operations,” Journal of Bank Cost &
Management Accounting, 2000, Volume 13, Number 3.
Kawano, Randall T., “Funds Transfer Pricing,” Journal of Bank Cost & Management
Accounting, 2000, Volume 13, Number 3.
Kimball, Ralph C. “Innovations in Performance Measurement In Banking,” New England

Economic Review, May/June 97.
* This article was previously published in the Journal of Performance Management in Volume 17 #2.

Transfer Pricing Capital *
By Alexander Kipkalov, Washington Mutual
By Alexander Kipkalov, Washington Mutual
alexander.kipkalov@wamu.net
alexander.kipkalov@wamu.net
Recent dramatic interest rate volatility has created problems and attracted significant
Recent dramatic interest rate volatility has created problems and attracted significant
attention to Funds Transfer Pricing methodology – one of the fundamentals of
attention to Funds Transfer Pricing methodology – one of the fundamentals of
performance measurement in the financial services industry. The ensuing, and
performance measurement in the financial services industry. The ensuing, and
sometimes emotional, discussions among performance measurement and ALM
sometimes emotional, discussions among performance measurement and ALM
practitioners have mostly been concentrated around how to transfer price deposits and
practitioners have mostly been concentrated around how to transfer price deposits and
explain the volatility in the funding unit’s income.
explain the volatility in the funding unit’s income.
They have also questioned some basic principles of FTP used by institutions for many
They have also questioned some basic principles of FTP used by institutions for many
years. With the accelerated development of internal Economic Capital (EC) techniques
years. With the accelerated development of internal Economic Capital (EC) techniques
boosted by the Basel II Accord, transfer pricing of allocated capital became a hot topic
boosted by the Basel II Accord, transfer pricing of allocated capital became a hot topic
too.
too.
This issue is particularly important for institutions with significance interest rate risk
This issue is particularly important for institutions with significance interest rate risk
exposure like thrifts or banks with large mortgage portfolios. By design, FTP reduces or
exposure like thrifts or banks with large mortgage portfolios. By design, FTP reduces or
eliminates volatility of the interest margin in the business units and concentrates it in the
eliminates volatility of the interest margin in the business units and concentrates it in the
Funding Unit, thus creating a potential for material income or loss position. Incorrect
Funding Unit, thus creating a potential for material income or loss position. Incorrect
FTP treatment of EC can change profitability of the product, business line or a customer,
FTP treatment of EC can change profitability of the product, business line or a customer,
but more importantly, it can create material volatility of the Funding Unit’s income.
but more importantly, it can create material volatility of the Funding Unit’s income.
Economic Capital has a strong inherent relationship with FTP methodology. Both are
Economic Capital has a strong inherent relationship with FTP methodology. Both are
based on the desired credit rating of an institution or a portfolio1. A company with an A+
based on the desired credit rating of an institution or a portfolio1. A company with an A+
credit rating will use A+ senior/subordinated debt rates as its funding curve. The rating
credit rating will use A+ senior/subordinated debt rates as its funding curve. The rating
will also determine the confidence interval for economic capital allocation.
will also determine the confidence interval for economic capital allocation.
FTP and EC both share a market risk component. FTP extracts most of the interest rate
FTP and EC both share a market risk component. FTP extracts most of the interest rate
risks from business lines and aggregates it in the Funding Unit. This risk should be
risks from business lines and aggregates it in the Funding Unit. This risk should be
measured and managed centrally. If a company makes the decision to leave some types of
measured and managed centrally. If a company makes the decision to leave some types of
market risk2 in the business units, economic capital should be attributed to the units for
market risk2 in the business units, economic capital should be attributed to the units for
these risks.
these risks.
EC is a measure of risk, but it is also used to calculate how much of a company’s equity
EC is a measure of risk, but it is also used to calculate how much of a company’s equity
should be allocated for the risk. This allows us to treat EC as a proxy for allocated equity.
should be allocated for the risk. This allows us to treat EC as a proxy for allocated equity.
FTP methodology ensures that the Funding Units pays a credit to the providers of funding
FTP methodology ensures that the Funding Units pays a credit to the providers of funding
sources. These sources of funds include deposits, other borrowings and equity. As a
sources. These sources of funds include deposits, other borrowings and equity. As a
source of funds, equity, and correspondingly, EC should receive an FTP credit. The
source of funds, equity, and correspondingly, EC should receive an FTP credit. The
amount of the credit and the calculation method relies on the FTP methodology adopted
amount of the credit and the calculation method relies on the FTP methodology adopted
by an institution. We recommend using the Cost of Funds Reduction approach because it
by an institution. We recommend using the Cost of Funds Reduction approach because it
is simple, elegant and the most efficient to implement.
is simple, elegant and the most efficient to implement.
1
Some institutions
1 make decision to assign lower cost funds for portfolios in order to achieve competitive
Some institutions make decision to assign lower cost funds for portfolios in order to achieve competitive
advantage in pricing. In this case capital allocated will be higher. For example portfolio funded with AA-
advantage
rated curve would have toinhold
pricing. In this
capital case
at AA capital allocated
confidence level. will be higher. For example portfolio funded with AA-
2 rated curve would have to hold capital at AA confidence level.
For example,2 Convexity, Basis, Vega etc.
For example, Convexity, Basis, Vega etc.
TRANSFER PRICING CAPITAL 27
Performance Metrics and Funds Credit for Capital
To measure performance, whether of a business unit, product or a customer, we must
calculate return relative to the size of investment, and to the risk contributed by the
investment. The latter is measured by Economic Capital (EC). This risk/return
relationship is the basis for multiple performance metrics. Measuring EC’s effect on the
return through FTP can shift the relationship significantly, particularly in the case of
high-risk assets. In this section we will briefly describe principles of the two performance
metrics that will be used in illustrating the different ways of transfer pricing capital.
There are two main categories of performance metrics used by financial institutions. One
is based on the ratio of modified return to the level of risk (RAROC, RORAC, ROEC)3,
another is based on considering earnings over and above the shareholder’s required return
allocated for the level of risk (SVA, NIACC, EP)4. We will use Risk Adjusted Return on
Capital (RAROC) to illustrate the concept of the capital credit.
(NII– OE – EL)*(1-T)
RAROC =
EC
Where:
NII – Net Interest Income

OE – Overhead Expenses
EL – Expected Credit Loss
T- Corporate Tax
EC – Economic Capital
As long as RAROC exceeds the shareholder’s required return or hurdle rate, the
investment increases profitability and return to the shareholders.
The largest variable in the RAROC equation is Net Interest Income (NII): that is, the
interest income from assets, interest expense required to finance the asset, and any
additional income provided by the attributed economic capital. The origin and size of this
latter portion - income from the attributed EC - is at the center of the disagreement among
FTP practitioners. We came across at least three methods of calculating the FTP credit on
EC used by financial institutions: (1) duration of allocated equity, (2) investment and (3)
a cost of funds reduction. Although all three stem from the same underlying idea, each
one can lead to different results. We consider the last one (funding cost reduction) the
most accurate and straightforward.
3
RAROC – Risk Adjusted Return on Capital; RORAC- Return On Risk Adjusted Capital; ROEC- Return
on Economic Capital.
4
SVA-Shareholder Value Added; NIACC-Net Income After Cost of Capital; EP- Economic Proft.

Duration of Equity5 Approach
This method would be commonly used in institutions that determine their FTP rates
based on the duration of financial instruments. Duration is the price change of a financial
instrument in reaction to the instantaneous shift of the spot yield curve. Change in
duration are measured in percentage of the price change, or in years.
The duration of equity quantifies equity price sensitivity to unparallel price changes in
the asset and the underlying funding instruments (liabilities) in response to interest rate
shifts. The fundamental relationship is expressed in the following formula:
D *A = D *L + D *E
Where:
D – Duration of an Asset
A- Dollar Size of an Asset
D – Duration of liability (funding instrument)
L – Dollar Size of the liability
D – Duration of Equity
Modifying the equation we have:
D = (D *A – D *L)/E
This formula determines the way equity can be transfer priced. If an institution decides to
extract interest rate risk by assigning liabilities to assets with matching dollar durations,
the implied liability assigned to the assets through the FTP process will have to cover all
ranges of the price change, then:
D *A = D *L
And
D *E = 0
In this case, no interest rate risk remains, that’s why the duration of equity is zero
Therefore the risk free overnight rate should be applied6.
This approach heavily relies on having a perfect ALM model and strong coordination
between ALM and FTP groups. It also becomes very complicated in implementation,
specifically for instruments with high optionality7.
5
We use attributed equity and economic capital interchangeably. This example is favored by the ALM
practitioners and we chose to use term equity as more commonly used in the ALM analysis.
6
The overnight Fed Funds rate is the closest feasible approximation to an instrument with zero duration.
7
The problem of optionality in FTP methodology is a large enough topic to be described in the separate
paper.

Investment Approach
This approach is popular among market analysts working with individual portfolios of
securities because of its simplicity and transparency. RAROC for a security or a portfolio
of securities is calculated with Option Adjusted Spread8 and Return on Economic Capital:
(OAS – SC – EL )(1 – T) Rf(1-T)*EC

RAROC = +
EC EC
Return from the EC
(OAS – SC – EL )(1 – T)
RAROC = + Rf(1-T)
EC
Where:
OAS – Option Adjusted Spread
SC- Servicing cost (all expenses associated with the portfolio management)
EL – Expected Credit Loss
T – Tax rate
Rf – Risk free rate (overnight Fed Funds rate)
In this scenario, an investor funds securities with a mix of debt instruments and
derivatives. The investor also has to keep additional equity capital (aka Economic
Capital) to cover the risk of potential losses from unexpected market movements. Rather
than keeping this capital in the form of cash, the investor would prefer investing it in
liquid financial instruments with minimal risk, hence the risk-free rate. This risk free
return is added to the return on security in the calculation of RAROC.
Applying this approach to the banking books (loans held to maturity) is challenging. In
order to calculate OAS, a market price should be available. Some of the banking books’
portfolios are quite unique and not traded on the market. There is also no way of
calculating OAS on non-earning assets and deposits. Since business unit performance
8
For any security with embedded options, OAS is the average spread over a chosen benchmark yield curve
one expects to return if holding the security to maturity (Riskglossay.com). OAS is the closest
approximation to the market-risk free spread – the altimate goal of the FTP methodology. If FTP takes care
of all types of market risk, the FTP spread (Yield minus FTP Cost of Funds) should be close to the OAS.

measurement requires transfer pricing the total balance sheet in a consistent manner, this
approach is not applicable to business unit profitability.
Another problem is the risk-free rate. If Economic Capital is assumed to be invested in

long-term government bonds, thus providing higher additional return, we overstate the
portfolios’ profitability in the short term. Moreover, long term government bonds are not
risk-free; they contain a significant amount of interest rate risk. Matching the term
(duration) of the investment with the term of capital return brings us to the next approach
– funding cost reduction.
Funding Cost Reduction
This approach is our favorite. It provides better reconciliation of accounting entries

without distorting profitability of product, business unit or customer. It is proved by the
following manipulation of the Net Interest Income (NII):
NII = A*Ra – D*Rd
Where:
A- Balance of the asset
Ra – Interest Rate on Assets
D- Balance of the debt to finance the asset
Rd – Rate paid on debt (FTP funding rate)
Substituting debt with assets and equity we have:
NII = A*Ra – D*Rd =
=A*Ra – (A-EC)*Rd =
= A*Ra – A*Rd +EC*Rd
The last equation determines the way FTP works in implementation. The FTP rate is
applied to the total balance of funded assets. A Credit on Economic Capital is added at
the same rate. So, it all translates to the same implementation techniques: FTP credit for
the full liability balance plus the Credit on Economic Capital.
This approach is simple and easy in implementation. Rather than calculating the duration
or term of EC, we take the FTP rate applied to assets and credit it to the attributed EC.
This assumes that capital is reinvested in the core banking business, not to the theoretical
risk-free instruments. The approach properly assesses profitability of any balance sheet
item, including non-earning assets, and provides better reconciliation between the
banking and FTP books.

Treatment of Liabilities
Our approach to assets is more or less straightforward. It took us longer to figure out the
logic for liabilities. Deposits receive an FTP credit based on the funding curve rate for the
appropriate duration. If we give an additional credit for the attributed capital, it looks like
an overstatement of the deposit’s profitability. However, our analysis determined that the
funding cost reduction approach does not have this effect.
In order to make it work, we suggest introducing “shadow assets”. From the Funding
Unit’s perspective, these could act like a bond issued to the business line with the coupon
corresponding to the FTP credit. The size of the bond will equal the size of the liability
and EC together. This “shadow asset” does not need to be booked in the General Ledger
and is used to calculate the proper FTP rate. The net interest margin for a “shadow
asset” would be determined by the coupon (Rc) and the interest paid (Rd) to the customers
on deposits:
NIM = SA*Rc – D*Rd =
= (D+EC)*Rc – D*Rd =
= D*Rc – D*Rd +EC*Rd
Where:
SA – Shadow Asset
Rc – Interest Rate on Liability (FTP credit)
D- Balance of the Liability
Rd – Debt rate (borrowing cost)
Example demonstrates that the same methodology works in the case of the liabilities.
Conclusion
As you can see from our presentation, we have a developed a thorough model for the
transfer pricing of capital. This model has evolved over time and has been well received
and supported by senior management. We suggest any organization attempting a similar
model should spend adequate time educating the key players on the issues, options, and
challenges with this model and implement in phases. Such an approach will have a
dramatic impact on the overall acceptance and use by the organization.

To FTP Or Not To FTP - That Is The Question! *
To FTP Or Not To FTP – That Is The Question!

by: W. Randall Payant, CRP
The IPS-Sendero Institute
When discussing funds transfer pricing (FTP), questions often come up about
transfer pricing capital, cash, fixed assets and other non-interest bearing balance
sheet positions. Some practitioners say, “Transfer price the entire balance
sheet!” Others say, “Transfer price only the interest-related sources and uses of
funds.” So there are several plausible responses to this seemingly benign
question.
At first blush, the idea of transfer pricing the entire balance sheet seems ideal.
After all, one role of FTP is to value the sources and uses of funds for
performance measurement purposes, so why not include everything? FTP is
often used as a relative contribution measurement mechanism for allocating the
net interest margin (NII) between funds providers and users. It is used to create
responsibility for the NII. But too often FTP loses value by jumping into the
numbers without having a clear understanding of the objective in the
measurement process.
“OK, let’s include everything” would be a good initial response, until it hits you
that financial accounting rules often create balance sheet accounts that are
neither sources nor uses of funds. Rather they are accounts necessary to create
the accounting fiction often reported as accrual-based net income. Accrued
interest receivable and payable, accrued depreciation, loan loss reserves, etc.
are examples of such accounts. None of these accounts come into play in
deriving the bank’s net interest margin, so why include them when assigning
responsibility for the margin?
So we are now back to transfer pricing only the sources and uses of funds.
Every source and use of funds does influence the margin. Some are interest
bearing, others aren’t. Capital (source), cash and fixed assets (uses) are all
examples of non-interest bearing accounts (zero rate customer deposit accounts,
non-accrual loans and OREO are really interest-bearing at a rate of zero).
Rightfully non-interest bearing sources and uses of funds should be considered
within the funds transfer pricing mechanism.
So how should we include them in FTP? To do so begs the question, “What

transfer rate should be assigned to cash, fixed assets, and capital?” Applying
matched-term transfer pricing principles implies that, upon their acquisition, a
determination be made of their term. As they have no defined term, one needs
to be hypothesized. Cash has a nil term. Fixed assets’ economic life may be
substantially different than the term over which they are depreciated for financial
accounting purposes. For capital (tier one) some might argue its term is in reality
a byproduct of management’s past net asset investment term decisions.
TO FTP OR NOT TO FTP - THAT IS THE QUESTION! 33
June 19, 2003 1 W. Randall Payant, The IPS-Sendero Institute

Assuming we can come to some conclusion as to cash, fixed asset and capital’s
original term, we can assign credit for capital provided and a cost of financing
cash and other fixed assets. These would be assigned to the unit responsible for
having decision-making responsibility over these sources and uses of funds.
As we continue in this line of reasoning, we conclude there can be significant

result differences transfer pricing all sources and uses of funds versus transfer
pricing only interest-bearing balances. When the amount of non-interest bearing
sources equals the amount of non-interest related uses, the net effect of transfer
pricing these balances is nil. However the difference grows when the volume
of non-interest bearing funds sources is significantly different than the volume of
non-interest bearing assets. We can derive even larger differences when the
transfer rates on non-interest bearing funds sources are different than transfer
rates on non-interest bearing funds uses.
But let's step back to ask the question "Why transfer price capital and non-
interest earning assets?" rather than "How can we include them in FTP?"
Granted, every source and use of funds should be considered within the overall
profitability measurement framework. Capital (source) and cash & fixed assets
(uses) must be considered. The issue is how best to include them...where and
why.
Capital is provided from shareholders who, through the Board, hire executive
management to oversee their capital and provide a shareholders return. So the
business unit responsible for capital is...executive management. Some FTP
practitioners assume the funding center or treasury manages capital, but no CEO
worth their salt would claim they delegated responsibility to manage this ultimate
resource to others lower on the organization’s totem pole.
So, to the extent capital is transfer priced, credit should go to the executive
management unit. And executive management better deliver something north of
a 15% return if they expect to stay around for long. The best thing about the
15%+ return bogey is that executive management can call on every unit to
contribute to achieving this overall return. So if executive management directly
provides capital to other units, the minimum transfer rate should be the rate
shareholders expect their capital should be earning.
Next we turn to transfer pricing real funds-using non-earning assets. Let's first
explore fixed assets, or what some refer to as "capital assets". Again we need to
ask the question "Who has management decision discretion over these assets?"
Most capital asset expenditure decisions are made by...you guessed
it...executive management. Yes unit managers make requests...but executive
management makes the acquisition decision. Expensing fixed asset acquisition
costs into the P&L comes through a depreciation charge to the business unit
granted use of the assets. This charge is below the transfer-priced NIM P&L line.

Essentially executive management "rents" the fixed assets to the business units
through these below-the-margin expense charges. So the use/consumption of
fixed assets is considered elsewhere in the profitability measurement framework.
Executive management creates the need for financing fixed assets. Therefore
executive management should bear the transfer pricing charge for fixed assets
financing.
Now cash...another term-less asset and use of funds required to run the bank.
Unless cash is poorly managed...and in a tiny number of banks it is...the amount
of cash maintained is no greater than legally required. Legally required cash is
predicated on other balance sheet amounts (namely deposits in many countries).
Most units do not maintain separate cash accounts. Others maintaining till cash
often do not manage the balance sheet positions that mandate legally required
cash.
Outside the minimal till cash kept by tellers, ATM machines, etc., the money desk
manages a majority of the bank’s cash. The money desk is usually associated
with the funding center. As a non-earning asset, cash has an implicit time value
of itself. Some theorists argue it depreciates in value due to inflation,
so cash's transfer rate should mimic the inflation rate. Other practitioners
suggest units holding cash are ultimately holding the shareholders’ capital in the
form of cash and therefore should be charged the same rate as
capital…something north of 15%. If this were the case, units holding non-earning
cash would argue they should charge units that get transfer credit for the
deposits that mandate legally required cash.
While this can be accomplished within an FTP framework, it is problematic

whether striving for such allocation precision changes the behavior of the unit
managers being measured. Here is the point: If capital is transfer priced, credit
rightfully goes to the executive management unit, as would the charge for funds
used to support fixed assets. Any net difference between these sources and
uses of funds is minimal and ends up in the funding center. Other business unit
managers don't have much influence on these non-interest bearing sources and
uses of funds...so why burden them with non-actionable assignments?
In an overall profitability measurement framework, capital is assigned to business

units based on their unique risk profile, not through transfer pricing. Transfer
rates reflect the time value of money, occasionally adjusted for a liquidity risk
premium. Transfer rates do not reflect premiums for the plethora of other risks
residing in the business unit. In order to derive a comparative RAROC of
business units, capital is assigned subsequent to transfer-priced measurement of
return.
So when all is said and done...transfer pricing all the balance sheet makes the
cost accountant within happy...because every source and use of funds is
considered. But after considering the value and relevance of transfer pricing

TO FTP OR NOT TO FTP - THAT IS THE QUESTION! 35
non-interest related balance sheet positions, in most cases, it’s quite a useless
exercise.
Including non-interest related balance sheet items clouds analysis of units'

manageable activities. Profitability measurements must be as transparent as
possible, if they are to be accepted and used. Hiding capital assignments within
the funds transfer-pricing mechanics is vacuous. Capital assignment and the
consumption of fixed assets are considered outside of FTP, but still within an
overall profitability measurement framework.
Einstein had the answer to this FTP conundrum, "Some things we can count
aren't worth counting, and things we want to count, we can't." Transfer pricing
non-interest related items falls into the first category.

CONTACT INFORMATION
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80 THE JOURNAL OF BANK COST & MANAGEMENT ACCOUNTING

Journal of Performance Management: Best Practices & Strategic Value of Funds Transfer Pricing

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Journal of

Best Practices & Strategic Value of Funds

Funds Transfer Pricing:

Transfer Pricing Capital

To FTP Or Not To FTP - That Is The Question!

Volume 22, Number 2

Submit manuscripts to:

(317) 815-5857 FAX: (317) 815-5877

AMIfs Research Committee

The Research Committee can be contacted by email at Research@amifs.org

For a complete list of previous Journal issues, refer to the

Best Practices & Strategic Value of Funds

Funds Transfer Pricing:

Transfer Pricing Capital .............................................................................. 27

To FTP Or Not To FTP - That Is The Question! ........................................ 33

n Leadership: Develop opportunities for members to advance the

n Research: Identify and coordinate research activities that support

n Education & Training: Provide professional development

n Networking: Provide opportunities for members to interact and

n Other Member Services: Provide related services that add value

n Infrastructure: Establish and maintain an organizational structure

JOURNAL OF PERFORMANCE MANAGEMENT 2

About the Author:

Financial institutions (“FSI”) eagerly seeking a competitive advantage understand and

BEST PRACTIVES & STRATEGIC VALUE OF FUNDS TRANSFER PRICING 3

Roles and Strategic Benefits

Funds transfer pricing is an internal management information system and methodology

importance cannot be over emphasized. Increasingly FSI executives acknowledge FTP

as the most essential component of a well developed and comprehensive profitability

measurement system. Matched-term FTP is the only path to measuring, understanding

methodology as provided by instrument level matched-term FTP.

designed FTP system, a FSI will be able to:

 Measure and segregate net interest margin risk components.

 Achieve improved net interest margin accountability and segregation of duties.

Highly successful executives have always understood the fundamental management

accountable for an important performance factor no one is accountable. Matched-term

FTP adheres to these fundamental management truths.

Financial instrument by financial instrument, each source of funds, such as a deposit or

of their origination. This valuation is accomplished by assigning each financial

instrument an associated transfer rate from an appropriate transfer curve(s). The

associated transfer rate mirrors as closely as possible the underlying financial

accomplished by this instrument by instrument valuation. With this instrument level

well as at the business unit, product and customer levels.

BEST PRACTIVES & STRATEGIC VALUE OF FUNDS TRANSFER PRICING 5

prepayments or early withdrawals, the transfer rate should do the same.

bonds, LIBOR, advance borrowings offered by governments and their agencies,

based upon a combination of these choices such as use of an overnight government

advances for the long-term.

1. Curve(s) should represent the opportunity cost or benefit of the funds.

2. Curve(s) should represent marginal wholesale rates.

3. Curve(s) should be derived from reliable and readily available data

4. Curve(s) should be credible as well as understood by and acceptable to

FTP users such as lenders, investment officers, liquidity managers,

branch deposit gatherers and treasury personnel.

tailored to their unique business model of incremental funds deployment and

procurement: a market-based alternative investment curve for deposits and borrowings

BEST PRACTIVES & STRATEGIC VALUE OF FUNDS TRANSFER PRICING 7

The matched-term FTP method is performed financial instrument by financial instrument

wed to a 5.25% transfer expense rate, representing the market-based incremental

deposit spread must also generate an adequate profitability return.

deposit spread must also generate an adequate profitability return.

adequate profitability return.

 early withdrawal penalties, reserve requirements