Fund Transfer Pricing (FTP) deserves more…

Fund Transfer Pricing (FTP) invariably is one among the most debated topic in a financial institution (if the institution has one) soliciting interests from business functions and control functions. Literature on Banking & Finance sufficiently acknowledges FTP as an important part of a bank’s asset & liability management (ALM) and adds to FTP theory by discussing governance, management, methodology and implementation of FTP. Primary objectives of FTP, as widely accepted, include proper distribution of revenues, objective performance evaluation of business functions and managing certain risks through proper transfer pricing. 

This article attempts to present the concept of FTP in relatively simple terms, provide a summary assessment of maturity/understanding level of organizations/professionals regarding FTP and how it intuitively links to FTP methodology adopted. Lastly, this article attempts to present a case for a higher pedestal that FTP mechanism could/should be elevated to.

FTP in slightly less technical terms

 FTP in banking and finance draws its parallel from Transfer Pricing in Management Control Systems (MCS). MCS refers to a set of formal or informal processes and structures established by a business to ensure that the actual outcomes are in-line with goals and strategy of the organization.

When an organization has decentralized structure, goods and services are transferred through various internal value adding centers (or profit centers) before the final product/service enters the market. In order to assess the contribution of each value adding center, management has to uniformly quantify for the value added at each transfer of goods and services. This can be achieved through a mechanism called “Transfer Pricing” wherein internal fictitious markets within a company are created for exchange of intermediate goods and services. In a manufacturing parlance, simplistically, this would mean manufacturing department buying raw materials from procurement department at a price called incoming transfer price and selling the finished goods to sales department at a price called outgoing transfer price (difference between the two being the profit). Fund Transfer Pricing in a bank conceptually follows a similar construct as shown below:

However, the similitude probably ends here with FTP being increasingly seen as a powerful tool (by regulators and practitioners alike) to drive right business and risk behaviours in the field of banking & finance.

FTP maturity level

Despite being around for a reasonable span of time, the concept of FTP has not been unanimously honored with its rightful place in the industry. The appreciation of FTP among practitioners varies from an elementary “left pocket right pocket” concept to a more evolved “Risk management and strategic tool”. Common perception of FTP being used just for performance evaluation, often renders the methodology & implementation of FTP vulnerable to frequent discussions/disagreements. But it is only when one sees the likely impact in its entirety most (not all) discussions would appear futile. The understanding/maturity of an organization with regards to the concept of FTP usually determines the methodology adopted (refer to the table below).

FTP deserves a higher Pedestal

You will see it when you believe it …

There is little doubt that Balance Sheet (and its management) for a Banking company is uniquely different. Increasing regulations around capital and liquidity are exerting a downward pressure on bottom lines of banking companies. It is turning out to be a complex optimization problem which requires understanding of complex interaction between balance sheet structure, profitability, capital and liquidity.  The most important step to solve this complex problem and accordingly drive profitable business behavior is to accurately factor in and allocate all direct/indirect costs/income (including funding, liquidity buffer, capital costs). FTP mechanism at a bank should be augmented to include relevant product/business/risk specific spreads to objectively capture these nuances of the aforementioned optimization problem. 

Organisations and their senior management often have unique strategic goals to be achieved. Additionally, Regulators/Governments in specific jurisdictions may want to achieve specific goals through respective financial systems (an example may be Priority Sector lending in India). FTP mechanism can be one of the useful tools in driving towards those unique strategic and specific goals by incorporation of “Strategic Spreads”.

Accordingly, FTP mechanism would have elements specific to an organization depending on its current level of interaction between balance sheet structure, profitability, capital & liquidity and specific objectives that the organization chooses to pursue.

More often than not, banks while developing their FTP mechanisms take very pedantic academic approach in justifying their FTP methodologies. This way the focus is diverted from the “bigger picture”  and diluted by discussions on product level profitabilites or performance assessments often denigrating FTP to just “left pocket right pocket” status. This does not mean FTP mechanisms/methodologies should not be debated, however, complexity and strategic objectives should be given their due weightage.

Conclusion

FTP mechanism should be seen as a strategic tool in exerting management control with the objective of managing the complex interactions of regulations with risk and profitability of a banking company. FTP mechanisms developed with a view towards the strategic goals would be less prone to denigration and debate. Having said that, FTP mechanism should be reviewed frequently and amended to ensure its effectiveness in managing balance sheets and achieving stated goals.