UNDERSTANDING PROFITABILITY THROUGH FUNDS TRANSFER PRICING · understanding profitability through...

UNDERSTANDING PROFITABILITY THROUGH FUNDS TRANSFER PRICINGA GUIDE TO FTP FOR FINANCIAL INSTITUTIONS

Understanding Profitability Through Funds Transfer Pricing2 © Copyright 2016 by Kaufman, Hall & Associates, LLC

Funds Transfer Pricing (FTP) is the most essential piece in understanding the rofitability of custo ers roducts organi ational units channels etc ithin a financial institution naly ing ho the arious contributors to net interest argin i act o erall rofitability leads to ore infor ed and

recise decision a ing regarding roduct ricing and other ey dri ers of rofitability for the institution

Unfortunately any financial institutions ha e focused on gaining recision in the calculation of the FTP rate but they fall short in their

analytical re orting ee er analysis of FTP results can lead to better ricing decisions and allo s your institution to get a better handle on the

dissection of performance.

IntroductionThe Role of Funds Transfer Pricing in Profitability


agine a ban that has ust t o custo er transactions originated on the sa e day a three year loan at and a si onth at The co bination of the t o transactions results in a net interest argin for the ban of t first blush it a ears that the loan generates

of the re enue and the de osit of the e ense ne ight co e to the conclusion loans are great and de osits a necessary e il no insert FTP y adding a funds transfer echanis s ecifically

an a ro riate funds transfer ricing yield cur e a co letely di erent icture as illustrated belo e erges

The inclusion of a transfer ricing cur e radically changes the understanding of the a eu of net interest argin and ho the ban s acti ities ha e contributed to it For ta ing credit ris in the for of a three year fi ed rate loan the institution earns a s read of abo e the atch funded oint on the cur e For sourcing funds in the local ar et in the for of a si onth the ban earns a s read of

ssentially the de osit gathering function is being re arded for the reali ed cost sa ings co ared to sourcing the sa e funding in the

holesale ar et

Finally for ta ing interest rate ris in the for of a is atched osition in this case lending long and funding short the institution earns

T U T

n llustration of Funds Transfer Pricing FTP

Three Year Loan 4.55%

Transfer Rate 3.30%Transfer Rate 3.30%

Spread of 1.25%

Transfer Rate of 2.10%Transfer Rate of 2.10%

Spread of .95%Spread of .95%

6 Month CD 1.15%

Spread Due toFunding Mismatch

1.20%

Spread Due toFunding Mismatch

1.20%

Net InterestMargin of

3.40%

Net InterestMargin of

3.40%


T U T

n llustration of Funds Transfer Pricing FTP

n the real orld ban s and credit unions ha e otentially illions of transactions in arious sha es and si es created o er a long eriod of ti e s such transfer ricing syste s are designed to rice each custo er record based on the e ected cash o s at the ti e of origination utili ing the interest rate en iron ent in lay at that ti e For e a le to rice the entire balance sheet the institution needs to ha e all the historic ter structures for their selected transfer

ricing yield cur e going bac as far as their oldest asset or liability ould re uire


ey le ents in easuring and e orting Funds Transfer Pricing in an s and redit Unions

ne of the first ste s the institution ust ta e in i le enting transfer ricing is defining their transfer ricing cur e The cur e should re resent

the institution s o n ability to source funds of arious ter s on the holesale ar et The a ur e is idely used as it re resents

the credit orthiness of non go ern ental entities a ro i ating an rating hich is a good ro y for a healthy ban ach institution should ad ust their transfer ricing cur e to re ect their ability to source funds in the market.

The rocess of deri ing an accurate theoretical cost of funds for a loan or an earnings credit for a de osit has e ol ed o er the years ell designed FTP syste s ill transfer rice each custo er record based on the cash

o characteristics of the record e g fi ed or oating rate ter cash o s at the ti e of origination or the last re rice date This is ty ically

called a atch funded a roach FTP syste s should assign a atchfunded transfer rate to each rinci al ay ent and then a alga ate these indi idual rates into a single rate based on a ti e balance eighted algorithm.

Handling outstanding loan balances and rinci al ay ents

Plotting margin against credit score

aluating loan originations by o cer

onsidering the ti e dimension


andling outstanding loan balances and rinci al ay ents

et s start ith an e a le of a t el e onth a orti ing loan ith a rate of and an outstanding loan balance declining through ti e due to eriodic ay ents ach rinci al ay ent re resents a artial retire ent of the o erall loan and is transfer riced using the a ro riate aturity oint on the cur e ince so e ay ents ha en early and others later a eighting factor is a lied to each

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rinci al ay ent to accurately ta e into account the length of ti e each ortion of rinci al is outstanding Fro this rocess an o erall composite transfer rate for the entire loan is calculated – in this case

The resulting s read is indicating that basis oints is needed to co er all the associated costs of originating

and ser icing this loan as ell as the target rofit


andling outstanding loan balances and rinci al ay ents (Continued)

Challenges to transfer price the balance sheet:

Accounting for unscheduled principal payments (“prepayments”)ost transfer ricing syste s su ort the ability to enter a re ay ent

assu tion about a articular tranche of loans s contractual cash o s are ro ected additional rinci al reduction is a lied hich accelerates the ayo of the loan thereby shortening the life of the outstanding

rinci al ach cash o stri contractual re ay ent is transfer riced n o tion ad usted s read ay be calculated and added

to the transfer rate to account for the o tionality of the loan

ccounts it no de ned cas o structureer the years di erent a roaches to handling these a biguous

accounts such as oney ar et sa ings accounts ha e e ol ed o e ha e focused on distinguishing core and olatile ortions of these accounts as a eans to deter ining their alue o e ha e used ore ad anced statistical ethods studying the beha ior of these accounts in di erent rate cycles to ascertain a i of funding that best correlates

ith the account s historic beha ior broad body of or is a ailable to enable the institution to beco e as recise as it desires in deter ining the theoretical atched rate for all account ty es on the balance sheet

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Plotting margin against credit score

Ty ical FTP re orting includes balances rates FTP rates and FTP s read for the ortfolio ust by adding the F score to e ery custo er record you can analy e hether ris based ricing is being i le ented by your loan o cers n the e a le belo of the uto oan ortfolio for the institution you can easily see the relationshi of the FTP s read on the y a is and the credit score the a is ach dot re resents the intersection of an indi idual loan s FTP s read and its credit score

2

ou ould e ect that the institution ould ha e a higher FTP s read for those loans ith a lo er credit score This institution basically has no ris based ricing as there is no easureable distinction bet een higher lo er credit uality loans e can see that this institution needs to ree aluate ho it is ricing its loans and the lac of correlation bet een its pricing and its risk.


Plotting margin against credit score (Continued)

e orting on so e ey infor ation about the ortfolio its si e eighted a erage rate s read and credit score sho s the eighted a erage s read of This rate is strong for the ortfolio but the scatter lot trend line highlights a lo er correlation bet een the ban s ricing and the borro er s credit rating scatter lot of detail ro ides a isual of the relati e relationshi bet een FTP argin and credit score hile the trend line of the data is odestly do n ard slo ing hich one ould e ect it is atter than the ris return rofile the ban e ects ecent

olicy guidelines sti ulate a graduated scale for argin targets gi en the underlying credit ris as easured by the credit score

2

u eri osing the ban s guidelines o er the ortfolio rofile one can see that nu erous loans are riced ell belo the desired threshold This is es ecially true for ris ier loans ith lo er credit scores The ban

ants to attract higher uality borro ers and this brief analysis indicates they need to enforce stricter guidelines es ecially in regard to ricing lo er uality credits This analysis suggests that the ban should be ore aggressi e in attracting higher uality borro ers than they are today The use of eighted a erage totals co bined ith relati ely straightfor ard data isuali ations results in so e eaningful insights buried in the original at list of loan records


aluating loan originations by o cer

n i ortant analytical tool that is often not fully utili ed in transfer ricing is incre ental analysis hile there is alue in understanding the

o erall contribution of a ortfolio one uic ly reali es the infor ation is not articularly actionable ortfolio s o erall balance and s read after transfer pricing is the aggregation of all historical lending decisions su ed together into one nu ber othing can be done about historic lending decisions that ere ade in so e cases any years rior ncre ental analysis allo s the institution to focus on recent acti ity hich is ore ertinent t hel s ans er the uestion hat s ha ening

no Focusing on current acti ity is ore actionable as it enables the institution to course correct if necessary t also ro ides a good indicator as to hether o erall s reads for the ortfolio ill directionally iden or narro based on ho loans and de osits are being riced today

eyond re orting incre ental analysis can be used for other ur oses such as incenti e co ensation Too often incenti e lans are not rightly aligned ith the institution s rocesses for easuring contribution Using the loan rofitability data by o cer the ban could de ise an incenti e lan that re ards loan o cers for the incre ental re enue they generate after transfer ricing reating the lin age bet een ho

e easure and ho e re ard ensures that the ban is sha ing the beha ior of its ersonnel in align ent ith its o erall cor orate

3

ob ecti es o e ban s ha e e tended this a roach to add econo ic ca ital and other factors to deter ine a ris ad usted return on ca ital

for a eriod s acti ities


aluating loan originations by o cer (Continued)

eg entation by loan o cer ro ides isibility into the contribution being ade by loan o cers n this e a le belo o cer led the

tea ith the highest olu e of ne originations but he as thirteenth in ter s of the s read the co bination of hich resulted in a ran ing for incre ental T contribution etailed data ay sho that cer has o erly sacrificed s read for the sa e of olu e

cer is ne to the ban and although she is building u her i eline she generates a higher argin on the fe loans she closed

3

during the uarter The re ort also highlights that this ar et has been able to originate and or re negotiate ter s on e isting credits at basis

oints o er the ortfolio a erage This is a good indicator that the o erall contribution fro this ar et should continue to i ro e e eraging this ie of the data anage ent is ar ed ith good infor ation to hel coach and anage their loan o cers in a ay that s i actful to the ban s rofitability and o erall erfor ance o ing for ard


The diagra belo dis lays the three ers ecti es for analy ing FTP for originated balances rates or total ortfolio T represents the current time period and is the calculated FTP rate of originated (or total) portfolio. PP re resents historical sna shots of re ious eriod results hich ill hel establish trends of ho roducts ha e been historically riced This beco es es ecially hel ful hen you add the loan o cer di ension and you can analy e ricing consistency through ti e FP re resents future ros ecti e eriod runo of the current ortfolio hel ing understand the impact of maturing spreads on portfolio performance.

onsidering the ti e di ension

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PP3 T0PP2 PP1 FP1 FP2 FP3

Recent Originations Projected Runoff (maturities,amortization, prepayments)

Segmenting the Time Dimension

What’s recently happened? What’s going to happen next?

4.79%

$92,745


onsidering the ti e di ension (Continued)

Three time perspectives to analyze for a more holistic view:

Current Performance (T0) uic ly ran hich loan o cers ha e originated the ost olu es in the defined ti e eriod t ill also ran the a erage FTP read and net inco e e ect balance ti es s read that has been boo ed for those olu es so anage ent can gain insight to the ricing decisions those o cers ha e ade

Historical Performance (PP1-x) naly e an o cer s historical ricing trends by roduct for any designated year co aring the to the o erall ban s FTP s read for the sa e roduct This infor ation ill gi e you an historical ers ecti e ho each o cer has riced ne balances by roduct and help management understand if underperforming pricing trends are aberrations or an ongoing roble

Prospective Performance (FP1-x) naly e the rinci al runo of the current ortfolio for any roduct and any o cer This assists in the budgeting rocess in hel ing to deter ine ne olu es and rates needed to meet targets.

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