Financial Risk Management: Applications in Market, Credit, Asset and Liability Management and Firmwide Risk

Chapter 7Funds Transfer Pricing and Profitability of Cash Flows

Funds transfer pricing creates a shadow of assets and liabilities. Real assets are funded by synthetic liabilities to produce a matched balance sheet for the asset. Similarly, real liabilities receive income from synthetic assets for the same purpose. Through fund transfer pricing a bank can analyze more efficiently its net interest margin and its expected profitability. Specifically, the net interest margin profitability and risk analysis can, with funds transfer pricing, be broken down to loan and position level. The same applies to a traditional economic value (solvency) view, which now also can be broken down to the most granular level.¹

Breaking down balance sheet profitability and solvency to the most granular level is important for segmenting the portfolio supplier versus consumers of portfolio profitability and solvency.

Traditionally, funds transfer pricing is used by financial institutions to:

1. Achieve centralization of risks, that is, clear branches' risks that are most efficiently managed centrally such as interest rate risk.
2. Measure ex-ante performance of traditional banking book items such as loans, mortgages, and deposits.

A loan or deposit clearing of interest rate risk is achieved through the funds transfer price, defined as the matched maturity funding rate plus a markup for business costs. In effect this is an interest rate swap agreement between the branch and the clearing center and the price ...