Funds transfer pricing is a method of measuring the profitability of a financial institution.
Every organization, as it grows, needs to keep a track of its profitability and this is an integral part of financial management of any financial institution. Tracing profitability value helps these institutions such as banks to gauge the strength and weakness of funding procedures they follow. Funds transfer pricing is a tool that helps these institutions in measurement of the profitability garnered by the various source of funds individually.
What is it?
It can be defined as a method to determine the measure of lucrativeness contributed by each source of funding, which in turn is used to gauge the strong and weak areas of funding within the organization.
From the above definition, it is clear as to what this tool is about. But how does it help to measure the gains and also indicate the profitability of the various product lines and staff? The answer lies in calculation of the net interest margin on funds gathered by the bank. Banks are a depot of funds. Their business depends on funds received from their prospective customers and third parties. Most of the time, the funds are stored as deposits or are lent as loans or are used for making investments. The financial agreements between the bank and its customers define the amount, term, and rate of interest for the funds deposited or invested. The net interest margin which is calculated by this tool depends on the interest payments of the loans lent. Also, the contributions made to net margin and value are not always equal. So, this method helps in assessing the overall profitability of the bank on the basis of the net interest margin.
How to Calculate it?
All financial institutions like banks maintain a funds transfer pricing curve, which is calculated by plotting yield to maturity against time to maturity. From this graph, the rate of fund lending needs of each branch of the bank is calculated and compared. But what is the source of fund lending? Net interest income! The biggest and the primary measure of a bank's profitability is net interest income, which accounts for approximately 80% of a bank's revenue. This income is used as one of the sources of fund lending. When a bank has to lend money, it will loan the desired amount from the deposits made. Each deposit has a token value registered by the funds transfer pricing tool. And for every deposit, the loan catering to it has a cost assigned. Hence, this financial tool is an integral component of profitability measurement process, that helps in calculation of net interest rate margin (IRM). The net interest rates are assigned to all earning assets to reflect the source of funding within the bank.
IRM = Interest earned on the funds used for investments - Interest expense on funds deposited
The calculation is usually done by pooled approaches or specific assignment approaches. In both the methods, a fund transfer rate is determined on the basis of allocation of contribution to overall net interest margin of the bank. In pooled approach, individual pools are created to assign funds to a specific pool under some preset criteria. For instance, in a single pool approach, the fund transfer rate based on asset yields, favors the fund user's contribution to profitability. The rate that is assigned to one single pool is calculated on basis of actual interest rates (earned/paid) or on interest rates derived in market. The shortcoming of this method is that, it is carried out on the assumption that all funds bear equal importance when contributing to the bank. Hence, this approach fails to differentiate the value based on the attributes of funds deposited. Nor does it take into account the market conditions and the time of transaction, when calculating the fund transfer rate. However, in a multiple pooled approach, every little attribute concerning the fund, like its maturity, the time of deposition, and the market behavior is taken into account. Precisely, this approach is an extrapolation of the single pool approach. Here multiple pools are created, each spanning the maturity spectrum of the funds. The pools containing funds with longer maturity rate receive a long-term rate. Similarly, short-term funds have a shorter rate. With the help of this tool, profit contribution value (PCV) to the funds can be calculated by the formula:
PCV = (customer interest rate - fund transfer rate) * number of funds
Where, the customer interest rate is the interest rate for the funds deposited in the bank.
An absolute precision of aggregate profit contribution is obtained by this method of funds transfer pricing.