What exactly is fund transfer pricing?

Fund transfer pricing is a method used by bankers to evaluate the profitability of deposits and loans. The challenge, in the case of the former, is as follows. When bankers evaluate the profitability of deposits, they know the cost – the interest to be paid on those deposits and the associated operating expenses (such as employee time and IT). However, determining the return is more problematic because deposits are used to finance various types of assets (such as consumer loans, corporate loans, interbank assets, bonds, and fixed assets). An identification of the revenue – known as the fund transfer price – must be made. In fact, it is absolutely essential for accurate pricing of the bank’s commercial products, not to mention performance evaluation and organizational strategy, to have a sound method of calculating the fund transfer price.

And for loans?

For loans, the problem is symmetrical. Bankers know the return on loans, that is, the interest income (net of the expenses incurred by bad debts), but not its funding cost. The reason in this case is that banks use several sources of funds to finance assets (such as demand deposits, savings deposits, time deposits, corporate deposits, interbank deposits, subordinated debt, and equity). Again, they need a specific fund transfer price to evaluate the cost of funding loans.

Why is fund transfer pricing so important right now?

It is particularly important in the light of the recent global banking crisis and the ongoing economic turbulence in the Eurozone. Added to that, implementation of the Basel III round of banking regulations will place an added pressure on banks to maintain a buffer of liquidity.

Can you give a specific example?

An official enquiry, by the Swiss Federal Banking Commission in 2008 found that one of the reasons for the debacle of UBS during the crisis was the evaluation of very risky assets booked in New York with a fund transfer price that reflected the high rating of the overall bank, rather than the products concerned.

What is the main issue today, in your opinion?

There are five issues, in fact, many of which have previously been ignored. And that is where it starts to get technical, sorry! The five issues are: rationing on the interbank market; the creation of a Basel III contingency liquidity buffer; the necessity to adjust fund transfer price to the credit riskiness of specific assets of the bank (as in the case of UBS that I mentioned); the need to include a liquidity premium in the case of long-term funding; and finally the choice of a consistent methodology to incorporate the credit spread on the bank’s own debt due to the perceived risk of bank default.

Could you summarize the problem in a slightly simpler way?

Basically, I believe the foundation approach to fund transfer pricing traditionally used by most banks is no longer sufficient. I have devised an advanced approach that takes into account each of the five issues I mentioned earlier. It is interesting to note that OECD countries can learn a great deal from banks in emerging markets, where the risk of banks defaulting is very real. Most important of all, however, senior managers and board members have to understand all of these issues if they are to ensure long-term value creation for their organizations, as opposed to short-term damage limitation.

Learning more at INSEAD

Learn more about Professor Dermine’s advanced methods for fund transfer pricing by clicking here to download his working paper on the subject. Alternatively, if you are a senior manager or board member of a bank, consider enrolling on one of the two Executive Education programmes that Professor Dermine directs: Risk Management in Banking and Strategic Management in Banking.