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Home > Financial Risk Management Best Practice > Understanding and Applying Funds Transfer Pricing

Financial Risk Management Best Practice

Understanding and Applying Funds Transfer Pricing

by Hovik Tumasyan

This Chapter Covers

  • The role funds transfer pricing plays in a bank.

  • The mechanisms used to perform funds transfer pricing is illustrated through numerical case studies

  • The methodological aspects of defining the transfer price rates for typical asset and liability instruments.

  • The chapter ends with reflections on the current state of affairs for funds transfer pricing frameworks.

Introduction

In its simplest form funds transfer pricing (FTP) is the process whereby the treasury of a bank (its funding center) aggregates funds centrally and then redistributes them throughout the business units, balancing funding resource excesses and shortages and thus creating an internal market for liquidity. If there is still a deficit for funds, the treasury raises more funds from the capital markets, and if there is an excess of funds, treasury invests them in capital markets or lends in the wholesale markets.

FTP has been an integral part of bank management for more than three decades. It traces its origins to the 1970s and the deregulation of interest rates in the United States, when it was developed as a tool for managing the interest rate risk in banks.1

Fundamentally, the purpose of FTP remains the same as it was when it was developed: to aggregate the interest rate exposure of the whole bank into a central location for its effective management. In doing so, FTP generates a few other results that sometimes are quoted as the main purpose of FTP:

  • by transferring the interest rate risk into a central location, it makes the booked income of business units immune to interest rate fluctuations;

  • by charging for such transfers, it effectively determines the net interest income of business units;

  • because banks acquire interest rate exposure in the process of funding their balance sheets, FTP is perceived as the mechanism of charging for funding costs and as a tool to manage the liquidity risk of the bank.

It has to be noted, however, that equating the management of interest rate risk to allocating the costs for funding can be an oversimplification in today’s banking organizations. The simplistic and directional view that higher interest rates increase the costs of funding, and that this risk needs to be managed against, seems to be reminiscent of times when all the loans (mortgages) in the banking books were fixed-rate (as far back as the 1970s and 1980s). Today, banking books have almost as much in the form of variable-rate loans indexed to a variety of alternative indices (which creates basis risk) as they have of fixed-rate loans. Moreover, interest rate management transactions are sometimes carried out between a banking unit (like retail) and a swap desk in the capital markets division, while the treasury charges a fixed rate for an overall use of resources.2

In the aftermath of the recent financial crisis, FTP has regained its prominent role as the key tool in measuring and managing the liquidity risk in banks.

In this chapter we will follow the funding cost allocation side of the FTP and will acknowledge the interest rate exposures en passant, distinguishing between the two in examples.

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Further reading

Books

  • Adam, Alexandre. Handbook of Asset and Liability Management: From Models to Optimal Return Strategies. Chichester, UK: Wiley, 2007.
  • Esch, Louis, Robert Kieffer, and Thierry Lopez. Asset and Risk Management. Chichester, UK: Wiley, 2005.
  • Matz, Leonard, and Peter Neu. Liquidity Risk Measurement and Management: A Practitioner's Guide to Global Best Practices. Singapore: Wiley (Asia), 2007.
  • Murphy, David. Understanding Risk: The Theory and Practice of Financial Risk Management. Boca Raton, FL: Chapman & Hall/CRC, 2008.
  • Van Deventer, Donald R., Kenji Imai, and Mark Mesler. Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. Singapore: Wiley (Asia), 2005.

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