Fund transfer pricing: An imperative for banking industry

2014 has been a challenging year for the financial services industry. The year started with uncertainties regarding national elections and investors remain watchful before and after the national election. We have seen the violence and political uncertainties in the last year the effect of which has been carried forward in this year too. As a result the disbursement of credit in the banking sector has remained slow. Central bank in the latest monetary policy targeted 16.5% private sector credit growth. However, the actual growth so far is well below the target and hovers around 11%. As a result the banking sector faces a different challenge with surplus liquidity compared to couple of years ago.
As a result interest rate has come down substantially in the last couple of years and banks are facing the problem of investing the funds in the productive sectors. As a result weighted average of money market rates have gone down to 6.5% in August, 2014 from 11.50% in August, 2012. Due to greater demand for government bonds the yield rates for Treasury bonds have gone down significantly. The following table suggests the declining rates due to the increase in liquidity in the banking sector.
Figure 1: Economic Indicators (Source: Bangladesh Bank)

The deposit and lending rates have gone down significantly from the levels seen a couple of years back. The net interest rate spread is also under pressure. With the increase in non-performing loans and decrease in interest rate spread the net interest margin has declined too.
If we look at the core business of the banks the objective is to optimize net interest rate margin. The banks have non-interest revenue from fees, capital gains, commissions and others but that too came under pressure with the slowdown of the economy in the last few years.
Also, with nine new entrants in the banking industry the interest rate margin is definitely under pressure and banks need to find ways to efficiently manage the net interest margin. In such a scenario banks are now required to focus more on how it account for the costs, benefits and risks of liquidity in their business activities. Though banks continue to work on their strategies to effectively manage liquidity and risk, they should also consider integrating fund transfer pricing (FTP) in order to better manage the interest rate margin.
How fund transfer pricing works: The liability management division acquires funds from customers in the form of deposits (CASA or TD), that are then passed on to the Treasury division for proper deployment. These funds are passed on to the Lending division for lending to customers as loans. In case of shortage of funds from Deposits for loans, Treasury procures additional funds from the wholesale market.  The interest earned on loans constitutes Interest Income; the interest expensed on Deposits is called interest expense and the difference between the two is called Net Interest Income (which is generally reported on the income statement).
Each deposit has its own value as a source for loans and similarly each loan has its own cost of funding. The purpose of FTP is to measure individually how each source of funding contributes to the overall profitability of the bank.
Benefits of fund transfer pricing:  FTP is an internal measurement and allocation system that assigns a profit contribution to funds gathered, lent, or invested by a bank. Transfer pricing is a critical component of risk transfer, profitability measurement, capital allocation, and specifying business unit incentives, as it allocates net interest income to the various products or business units of a bank.
By introducing and effectively implementing the FTP banks will be better able to manage several important issues.

A.     Banks will be able incorporate risk-return based product pricing framework which will be used as a basis for differential product pricing.
B.     The FTP will allow banks to centrally control the net interest margin. As a result management will have a better control on cost of funds.
C.    Banks will be able to manage structural liquidity mismatches which occurred due to borrowing short and lending long. Also, it will be possible to transfer interest rate risk and liquidity risk to a central unit (Treasury Department).  As a result capital will be reallocated base on risk-weighted performance parameters.
D.    Banks will be able to manage net liquidity across business units. One of the jobs of treasury department is to fund liquidity mismatches at an optimal cost. An effective FTP implementation will facilitate that funding at an optimal cost.
As the Basel committee introduced liquidity standards as part of the Basel III capital regime, including the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), banks need to work on their abilities to effectively manage liquidity and risk through robust and effective fund transfer pricing. Majority of our banks yet to introduce and implement the FTP policy due to added complexity and relatively high implementation and maintenance costs.
Since banks will start the implementation of BASEL III as per the guideline of Bangladesh Bank and since liquidity risk management appears to have returned to become an important topic for both banks and regulators, I think now is the time for our banks to introduce an effective and robust Fund Transfer Pricing Policy in order to better manage the net interest margin and to better control liquidity risk.
The writer is a certified financial risk
manager. He can be reached at: [email protected]