Fund Transfer Pricing - Essay Example

Business FinanceFund Transfer PricingFinancial institutions including banks operate in a highly competitive and complex landscape (International Banker 2014). Consumers are becoming more knowledgeable while brand loyalty is diminishing. Recent global turmoil in the financial sector has led to stringent regulatory restrictions and compliances (Bessis 2011). It is becoming difficult for banks to achieve growth amidst increasing capital requirements and unstable macro-economic conditions. These conditions have led to diminishing margins for banks and serve as obstacles to achieving sustainable profitability (Wyle & Tsaig 2012).

This situation warrants players in the banking sector to review their methodologies of reporting and measuring performance. This paper discusses the applicability of fund transfer policy as a measure of bank profitability.Commercial banks have two divisions: deposit and lending. The deposit segment accumulates funds from customers. These funds are lent to other customers as loans through the lending division. The interest that banks earn on loans is interest income while interest on deposits is interest expense (Kane 2007).

The difference between interest income and interest expense is net interest income and is reported on the income statement (Early 2001).It is not a guarantee that all loans are profitable neither do all deposits cause losses. Different deposits have varying values as sources of loans and in the same way, different loans have varying cost of funding (Macdonald & Koch 2006). The main purpose of finance transfer pricing is to measure independently how different sources of funding contribute towards the profitability of banks (Orlando).

IllustrationAssume a two-year loan financed by a three-month deposit. Assume also that the deposit segment acquires $1,000,000 worth of funds from the customer at a cost of 4%. These funds are passed to the treasury at a funds transfer-pricing rate. Assuming that the rate is 6%, the bank would earn a deposit spread of 2%. The treasury would then pass the funds to the loans department at a funds transfer-pricing rate of 8%. The loans department would then extend the loan to customers at an interest rate of 11%, earning a deposit spread of 3%.

On the other side, the treasury would earn a 2% spread for managing the interest rate risk that arises from the mismatch in maturity of funds. Assigning the funds transfer rate for treasury, the loans and the deposit divisions of the bank decomposes the spread earnings across the three divisions as illustrated below (Kawano 2000).Loan division2 year loan @ 11%2 year funding @ 8% (FTP)Lending spread=3%Deposit divisionInvestment @ 6% (FTP)3M deposits @ 4%Deposit spread = 2%Treasury division2 year funding @ 8%Investment @ 6%Treasury spread @ 2%After the funds transfer price for all financial instruments is set, various analyses of the business can be conducted using the FTP system.

These analyses are crucial in decision making as they provide a business insight to different areas of the business (Rice).Customer profitability Suppose a customer receives a loan at 11% and the cost of funding the loan, which is the FTP rate to the contract is 9%. In such a case, the bank would earn a spread of 2% from the customer. The FTP system is therefore handy in analysing the value of customers to a bank (Smullen 2001).Product ProfitabilityThe FTP system can be used to analyse products that are more profitable to the bank.

Contracts attract unique FTP rates based on the characteristics of the contract and the type of financial instrument. The contracts can be aggregated to measure a product’s profitability (Bessis 2011). Branch PerformanceThe management of a bank can use information relating to funds transfer policy to understand the cause of a decline in spread earnings for a given branch or to determine the performance of different branches (International Banker 2014).ReferencesBessis, J. (2011). Risk Management in Banking (3rd Ed.). Hoboken: John Wiley & Sons.

Top of FormBottom of FormEarly, B. (2001). Banker's guide to funds transfer pricing. Austin, Tex.: Sheshunoff Information Services.Top of FormBottom of FormInstituting a Funds Transfer Pricing (FTP)-driven Decision Enablement Framework in Banks. (2014, October 20). Retrieved January 29, 2015, from http://internationalbanker.com/banking/instituting-funds-transfer-pricing-ftp-driven-decision-enablement-framework-banks/Top of FormBottom of FormKane, E. (2007). Incentive conflict in central-bank responses to sectorial turmoil in financial hub countries.

Cambridge, Mass.: National Bureau of Economic Research.Top of FormBottom of FormKawano, R. (2000). Funds Transfer Pricing. Journal of Bank Cost & Management Accounting, 13(3).Top of FormBottom of FormMacDonald, S., & Koch, T. (2006).Management of banking (6th ed.). Mason, Ohio: Thomson/South-Western.Top of FormBottom of FormOrlando, H. (n.d.). Best Practices and Strategic Value of Funds of Transfer Pricing. Journal of Performance Management, 22(2).Top of FormBottom of FormRice, J., & Kocakulah, M. (n.d.). Fund Transfer Pricing: A Management Accounting Approach within the Banking Industry.

 Journal of Performance Management, 22(2).Top of FormBottom of FormSmullen, J. (2001). Transfer pricing for financial institutions. Cambridge, England: Woodhead Pub.Top of FormBottom of FormWyle, R., & Tsaig, Y. (2012). Implementing High Value Funds Transfer Pricing Systems. Moody’s Analytics.