MSC in Finance and International Business

Author: Lukasz Kugiel

Academic Advisor: Morten Jakobsen

Fund Transfer Pricing

in a Commercial Bank

March 2009
List of contents
Introduction .......................................................................................................................5
1 General framework for Banking and financial risk .................................................. 7
1.1 Financial Intermediaries ................................................................................... 7
1.1.1 Transaction costs ...................................................................................... 7
1.1.2 Information asymmetry ............................................................................ 8
1.2 Definition of a bank.......................................................................................... 8
1.2.1 Access to payment system and financial liquidity.................................... 9
1.2.2 Asset transformation............................................................................... 10
1.2.2.1 Maturity transformation...................................................................... 10
1.2.2.2 Amount transformation....................................................................... 10
1.2.2.3 Information transformation................................................................. 10
1.2.2.4 Risk transformation ............................................................................ 11
1.3 Types of banks................................................................................................ 11
1.3.1 Investment banks .................................................................................... 11
1.3.2 Universal banks ...................................................................................... 12
1.3.3 Commercial banks .................................................................................. 12
1.3.4 Para-banks .............................................................................................. 13
1.3.4.1 Savings and loan associations ............................................................ 13
1.3.4.2 Credit Unions...................................................................................... 13
1.4 Central Bank ................................................................................................... 13
1.4.1 Monetary policy...................................................................................... 14
1.4.1.1 Open market operations...................................................................... 14
1.4.1.2 Discount rates ..................................................................................... 15
1.4.1.3 Reserve ratios ..................................................................................... 17
2 Financial markets and risks .................................................................................... 18
2.1 Financial markets............................................................................................ 18
2.1.1 Interbank deposit market ........................................................................ 18
2.1.1.1 Interbank interest rates ....................................................................... 19
2.1.1.2 LIBOR rates........................................................................................ 20
2.1.1.3 Alternatives to LIBOR ....................................................................... 21
2.1.1.4 Long term interbank rates................................................................... 21
2.1.2 Government debt markets....................................................................... 22

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 2.2 Managing risks ............................................................................................... 23
2.2.1 Credit risk ............................................................................................... 24
2.2.1.1 Individual risk..................................................................................... 24
2.2.1.2 Portfolio risk ....................................................................................... 25
2.2.2 Liquidity risk .......................................................................................... 26
2.2.2.1 Measurement of liquidity risk ............................................................ 26
2.2.2.2 Short term liquidity management ....................................................... 27
2.2.2.3 Long term funding management......................................................... 27
2.2.3 Interest rate risk ...................................................................................... 28
2.2.3.1 Measuring interest rate risk ................................................................ 29
2.2.3.2 Fixed interest income risk .................................................................. 30
2.2.3.3 Managing interest rate risk ................................................................. 30
2.2.4 Currency risk .......................................................................................... 31
2.2.4.1 Foreign exchange rates ....................................................................... 32
2.2.4.2 Currency risk measurement ................................................................ 32
2.2.4.3 Currency risk management................................................................. 32
3 Basic transfer pricing theory................................................................................... 34
3.1 Introduction to fund transfer pricing .............................................................. 34
3.1.1 The need for fund transfer pricing.......................................................... 34
3.1.2 Definition and objectives of a FTP system............................................. 36
3.1.3 Defining transfer prices .......................................................................... 37
3.1.4 Bank products ......................................................................................... 38
3.2 Single pool method......................................................................................... 38
3.2.1 Advantages and drawbacks of single pool ............................................. 39
3.2.2 Calculating internal transfer price .......................................................... 40
3.2.3 Net or gross balance ............................................................................... 40
3.2.4 Double pool method ............................................................................... 41
4 Multiple pool method ............................................................................................. 43
4.1 Market transfer prices..................................................................................... 43
4.2 Building pools of transactions ........................................................................ 44
4.2.1 Long term fixed rate products ................................................................ 45
4.2.2 Float and internal rate products .............................................................. 45
4.2.3 Blended term for indeterminate maturity products................................. 46
4.3 Calculating transfer rates ................................................................................ 47

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 4.3.1 Price period length.................................................................................. 47
4.3.2 Ex post or ex ante prices......................................................................... 47
4.3.3 Weighted moving average methodology................................................ 48
4.4 Adjusting prices for liabilities ........................................................................ 50
4.4.1 Deposit curve.......................................................................................... 50
4.4.2 Reserve ratio adjustment ........................................................................ 50
4.5 TPs for other assets and liabilities .................................................................. 51
4.6 Spread components in FTP portfolio.............................................................. 52
4.7 Corrective margins ......................................................................................... 53
4.8 Pros and cons of multiple pools...................................................................... 55
4.9 Historical multiple pool variation................................................................... 56
5 Matched rate method .............................................................................................. 57
5.1 Benefits of MRM............................................................................................ 57
5.2 Business unit results ....................................................................................... 58
5.2.1 Credit risk ............................................................................................... 59
5.3 Transfer price calculation ............................................................................... 59
5.3.1 Float rate transactions............................................................................. 60
5.3.2 Internal rates ........................................................................................... 60
5.3.3 Transactions of indeterminate maturity.................................................. 61
5.3.4 Fixed rate transactions ............................................................................ 62
5.3.4.1 Amortizing loans ................................................................................ 62
5.3.5 Prepayment option adjustment ............................................................... 63
5.4 FTP portfolio management............................................................................. 64
5.5 Variations of matched rate methodology........................................................ 65
Conclusion...................................................................................................................... 67
Bibliography ................................................................................................................... 70

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Introduction
This thesis presents the concept of Funds transfer pricing (FTP) - a process of interest
income attribution to internal contributors on various levels.
FTP is a crucial element of management accounting income calculation. The basic
problem of bank management reporting is the need to calculate profits on different
products and divisions in order to make informed business decisions. Interest, the
largest component of bank’s profits, is received on loans and paid on deposits. Without
FTP it would seem that all deposits generate only costs, whereas they’re the source of
funding necessary for giving loans. As a consequence, customers and business units that
only deposit funds without taking loans would be deemed unprofitable. FTP solves this
problem by setting and internal price that allows estimating the cost of financing a bank
faces and assigning it to users of funds.
FTP system allows not only to measure and report profitability in a variety of ways, but
also enhances institution’s profits. Studies show that all major banks and most of small
ones use some sort of fund transfer pricing system.
However, FTP is not always employed by small banks, especially in developing
countries. To some extent, it’s a result of lack of literature on this subject. Apart from
articles in specialized banking journals and technical manuals of implementation, FTP
is not widely presented in literature, especially in a more accessible approach. Academic
literature in particular tells very little about fund transfer. Information on FTP in
handbooks on banking is brief and cursory, resulting in insufficient understanding of the
subject among banking students.
The objective of this thesis is to emphasize the importance of fund transfer system for
banks and to present the most common FTP methods. The thesis also aims to answer
common questions about FTP:
• Is FTP necessary, or can a bank cope without it? Why is it necessary? What are
the dangers of not having an FTP system?
• What are the advantages of using an FTP system? Why are they important? Are
there any drawbacks?
• How can it improve results? Can FTP directly increase profits? What is the
effect on bank’s profitability and effectiveness?

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 • How to build an FTP system, is there an easy way to do it? Are there any simple
variations of FTP methodology? What are the basic components of a fund
transfer system?
• How to develop a perfect FTP system? What are its requirements? What are the
issues faced when implementing a complex FTP system?
The research approach used to answer those questions comprises building on academic
background on banking, financial markets and risks in order to introduce the theory of
fund transfer pricing. First, the role of financial institutions in transformation of
financial assets and liabilities is described. Altering maturities, amounts, currency and
interest rate characteristics of financial instruments entails various market risks for those
institutions. Interest risk, increased by the ever-changing market rates, is the main
challenge, followed by issues of liquidity and currency mismatch. Next, the need for
FTP is explained and advantages of various methodologies are listed. Attribution of
transfer prices to divisions, products, customers and transactions is described. Dilemmas
in the use of FTP are answered, such as choosing the relevant FTP method, calculating
and assigning transfer prices and liquidity margins and reconciling results through fund
transfer division.

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1 General framework for Banking and financial risk
This chapter outlines basic concepts in banking to the extent necessary in this thesis.
The following definitions and descriptions do not sum up to a complete theoretical
introduction to banking. Only the areas necessary to constitute a general theoretical
framework for Fund Transfer Pricing (FTP) are presented and further developed in
subsequent chapters. Concepts discussed below comprise bank functions and types,
including the Central Bank. These concepts are relevant to the thesis not only as a
source of basic banking vocabulary. Understanding bank products and services shows
the need to employ FTP system. For different types of banks, different models of FTP
are suitable. Further on, the central bank, by setting official rates and financial security
requirements, largely influences bank transfer prices.

1.1 Financial Intermediaries

Banks are specific financial intermediaries. In general, a financial intermediary is an
institution specializing in simultaneously buying and selling financial contracts and
securities.1
Their existence is justified by their intermediation skills, resulting in a number of
unique services they can offer to investors.

1.1.1 Transaction costs

Access to financial markets is costly, and requires expertise. Carrying out financial
transactions requires spending money and time. Transaction costs comprise monetary
costs, search costs and monitoring costs. 2
Financial intermediaries are able to reduce transaction costs due to:3
• economies of scope – a company dealing in a wide range of financial
instruments and transactions increases its efficiency;
• economies of scale – as the total size of the transactions of an intermediary
increases, the costs per unit of transaction are reduced. This is the case when

1
Freixas X. & Rochet J.C. 1999, Microeconomics of Banking, Massachusetts Institute of Technology,
Massachusetts, p. 15.
2
Benston G. & Smith C.W. 1976, ‘A transaction cost approach to the theory of financial intermediation’,
Journal of Finance 31, p. 215.
3
Freixas X. & Rochet J.C. 1999…, op.cit., pp. 18-20.

7
 fixed transaction fees are in use, or when indivisibilities (a minimum size of an
operation) take place.

1.1.2 Information asymmetry

Another justification of necessity of financial institutions is the problem of information
asymmetry. It is the case when one side of a transaction does not know enough about
the other side to make accurate decisions. This unequal knowledge appears before and
after the transaction is effected4:
• Adverse selection materializes before the transaction occurs. It is defined as a
tendency of the most risky borrowers (with possibility of large gains and large
losses) to be also the ones most actively seeking a loan. This leads to an
increasing percentage of loans being bad credit.
• Moral hazard appears after the transaction occurs. It is the risk of the borrower
engaging in risky activities that diminish the probability of loan being repaid,
inclined to do so by the fact, that he does not risk his money.
Financial institutions are more capable of dealing with information asymmetries than
individuals, due to large number of transactions and increased expertise.

1.2 Definition of a bank

There are many definitions of a bank and compiling them would result in a statement
similar to the following: Banks are financial intermediaries, whose current operations
consist of transforming deposits received from the public into loans.
This definition emphasizes the fact, that only banks lend and borrow money at the same
time as their main source of income. Moreover, banks’ main source of financing are the
deposits of the public, as opposed to financing mostly by issuing debt or equity.5
This basic banking function of transforming deposits into loans entails an important
problem – how to set prices for those two products? How to decide whether, at a given
price, it is still profitable for a bank to offer loans and deposits? These are the very basic
questions that FTP aims to answer.

4
Mishkin F.S. 2004, The Economics Of Money, Banking, And Financial Markets, Addison-Wesley, pp.
32-34.
5
Freixas X. & Rochet J.C. 1999…, op.cit., pp. 1-2.

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Banks fulfill several basic tasks. Not every bank does all of the following and other
financial intermediaries can fulfill some of those functions, however only banks can
provide all of them. Banks6:
• Ensure access to payment system,
• Guarantee financial liquidity,
• Allow for asset transformation,
• Take, manage and resell financial risk,
• Offer information on risk levels.

1.2.1 Access to payment system and financial liquidity

Historically, the initial banking activities were money changing, i.e. exchanging one
currency into another, and safekeeping of coins. Money was initially kept in banks for
security, not for profit, and was not invested into loans. Certificates were issued by
banks to confirm the amount of money stored in vaults.7
Storing money allowed for facilitation of payments between bank’s customers. If two
merchants had coins stored in one bank, it was easier to clear their positions through a
bank than to actually move coins, especially at a distance or when large amounts were
involved.8
Banks allow not only for execution of payments, but also for transfer of payments in
time. Credit lines permit postponing cash outflow, while factoring services allow early
recognition of cash inflow. Banks can be considered in this aspect as source of liquidity
for customers, facilitating transactions, ensuring quick conversion of their savings into
goods and allowing them to satisfy their consumption needs by transferring financial
resources in time.9

6
Cecchetti S. 1999, ‘The future of Financial Intermediation and Regulation: an Overview’, Current
Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 5, no. 8, pp. 1-2.
7
Kindleberger C.P. 1993, A financial history of Western Europe, Oxford University Press, Oxford, pp.
48-51.
8
Rochet J.C. & Tirole J., 1996, ‘Interbank lending and systemic risk’, Journal of Money, Credit and
Banking, vol. 28(4), pp. 733-762.
9
Freixas X. & Rochet J.C. 1999…, op.cit., p. 20.

9
1.2.2 Asset transformation
Banks play an important role as institutions capable of transforming financial resources
with regard to time, amount and risk level:10

1.2.2.1 Maturity transformation

Maturity transformation is necessary, because owners of financial resources typically
want their money deposited for short term, whereas borrowers would like to receive
funding for a longer term. Banks are able to transform short-term deposit into long-term
credit. Maturity transformation creates a risk that a bank won’t be able to repay a
depositor since his money could be “locked up” in a long term loan. This is a source of
liquidity risk.

1.2.2.2 Amount transformation

Amount transformation is the result of lack of size similarity between amount of money
deposited by an individual and the sum required by the borrower. Banks can adjust the
size of loans of deposits to the needs of their clients. Usually, depositors place small
amounts, while borrowers require large sums of money. Also, banks serve as
intermediaries between large-amount financial markets and individual retail customers.

1.2.2.3 Information transformation

Information transformation is a result of information asymmetry – when a borrower has
better information about the risk of the projects financed by loan than the lender does.
Banks have better information on risk of borrowers not repaying a loan than depositors
do. Intermediation of a bank increases the safety of funds lend to another party.
Banks are able to reduce initial risk of adverse selection by evaluating borrowers and
screening their investment projects. The ex-post risk of moral hazard can be controlled
by closely monitoring the situation of borrowers, by preventing opportunistic behavior
and by auditing the borrower that fails to meet loan obligations.11

10
ibidem, pp. 4-5.
11
Diamond D. 1984, ‘Financial intermediation and delegated monitoring’, Review of Economic Studies
51, pp. 393-414.

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1.2.2.4 Risk transformation
Risk transformation comprises of diversifying risk due to a large number of borrowers.
The process of risk sharing allows for creating assets with risk characteristics suitable
for different customers. This way the exposure of customers to risk can be reduced,
since risky credits are turned into safer assets. It is safer for a depositor to allow a bank
to lend his money to third parties than to issue loans by himself. Internally, a bank
diversifies risk by investing in a portfolio of loans which are less then perfectly
correlated, resulting in diminishing the overall risk. 12

1.3 Types of banks

The definition given in chapter 1.2. describes a commercial bank. There are however
different types of banks, with different scope of activities. Some banks focus only on
one side – either loans or deposits. Certain banks don’t deal in regular banking products
at all, focusing more on financial markets. Others do the opposite – offering services to
small customers only and not dealing in interbank markets. Some banks narrow their
scope to a small number of products. Finally, there are international differences in bank
types, resulting form local specifics.
Each type of bank has a version of FTP best suited to its products and services. Banks
that have access to wholesale financial markets as a source of borrowing set their
transfer prices differently than those that can access the market.

1.3.1 Investment banks

Investment banks are not really banks are defined here, that is, they don’t transform
deposits into loans. More precisely, investment banking activities are different from
regular banking. They provide direct financing on financial markets through debt and
capital. In detail, their functions include: private placement, dealing in derivatives, issue
broking, underwriting, portfolio management, investment funds, corporate financial
advisory, advice on mergers and acquisitions, global custody.
Due to the riskiness of some investment banking activities (especially dealing in
derivatives), authorities in most countries tend to separate those functions from regular
banking (especially gathering deposits from the public). In USA, the 1933 Glass
Steagall Act excluded investment banking activities from commercial banking. In legal

12
Mishkin F.S. 2004…, op.cit., pp. 31-32.

11
nomenclature, the disparity between commercial and investment banking is emphasized
by using the term “investment firms” (in EU) or “broker dealer (in USA) instead.13

1.3.2 Universal banks

Universal banks combine commercial and investment banking. In many countries, such
activities are restricted or discouraged by authorities. In USA, restricted universal
banking is allowed by the Gramm Leach Bliley Financial Modernisation (GLB) Act
passed in 1999, but only to the extent that US financial holding companies can own
commercial banks and investment banks as subsidiaries. In contrast, in Germany banks
can offer commercial and investment services under a single firm. In most European
countries however, universal banking is discouraged by regulatory authorities.14
Financial holdings are the most common way for a bank to develop abroad. Usually, a
bank deals in one country, and international expansion is attained by acquiring or
starting up separate subsidiaries in other countries. These subsidiaries act as separate
legal entities, whose shares are owned by the holding company.15

1.3.3 Commercial banks

Commercial bank is the most common type, dealing in loans and deposits, and having
access to financial markets. They raise funds mostly through deposits (checkable,
savings and time deposits) and use them to offer loans (mortgages, consumer and
commercial loans) and invest in debt securities (usually government and municipal).
The most common case of a commercial bank is a country-wide bank offering a full
range o services, although sometimes small banks are regional. Their existence is
supported by regulations, like in USA, where they are obliged by law to invest in the
same region where their deposits where gathered. In many European countries, regional
banks offer financing to local authorities, who are often their partial owners.
Other banks tend to specialise in a selected choice of products, offering them on a
national scale. Specialized banks usually focus mostly on one type of loan: mortgages,
consumer loans, car loans etc. They can also focus on a customer type, taking deposits
and offering loans to consumer or commercial clients.

13
Heffernan S. 2005, Modern Banking, Wiley Finance, London, pp. 23-24.
14
Ibidem, pp. 24-25.
15
Saunders A. & Walters I. 1993, Universal Banking in America: What Can We Gain? What Can We
Lose?, Oxford University Press, New York.

12
1.3.4 Para-banks
Para-banks are institutions restricted in some way from being a complete commercial
bank. Often those institutions are excluded from some of the regulations that banks have
to comply with, as a consequence being refused access to interbank market. There are
two main types of those institutions.

1.3.4.1 Savings and loan associations

Historically, the most important feature of savings and loans associations was their
ownership structure – every customer needed to buy a share in this institution. These
associations focused mostly on consumer loans and residential mortgages and acted
regionally. They didn’t have access to financial markets and were exempt from some of
banking sector regulations.
Nowadays, savings and loans associations are very similar to commercial banks. Due to
regulatory changes, cooperation of groups of associations and commercial banks’
intermediation between them and financial markets, they are able to compete in the
same markets as regular banks. Their characteristics vary between countries, but they
are present in USA and most European countries (they originated in Germany).16

1.3.4.2 Credit Unions

Credit unions are formed by a group of people, most often by employees of a company,
union members etc. Among themselves, they gather deposits and make small consumer
loans. Sometimes the company they work for can support them financially. These are
very small financial institutions that don’t offer any services outside a limited group of
members. Historically, there were some similarities between credit unions and savings
and loans associations, however the latter have significantly evolved, while the former
remained the way they initially were.17

1.4 Central Bank

Central Bank is a special type of bank, unique for each country. To be more precise,
there is one central bank in every single monetary area (e.g. the Euro zone). This
implies its main function, which is control over a particular currency, including its

16
Mishkin F.S. 2004…, op.cit., pp. 34-35.
17
Ibidem, pp. 35-36.

13
amount in the market and its price. Another function of central bank is being a bank of
banks for all commercial banks in one country, i.e. offering them loans and taking
deposits, as they offer to the public. These functions are described below, to the extent
necessary in this thesis.
This chapter describes those elements of Central Bank policy that are strictly relevant to
FTP. The construction of commercial banks’ transfer prices is largely influenced by the
reserve ratio, since the safety reserve required by authorities decreases the amount of
funding available and increases funding costs to the bank. Central bank rates have also a
general effect, as they influence market rates that are taken into account by transfer
prices.

1.4.1 Monetary policy

Monetary policy is the set of central bank’s actions that concern the national currency,
its supply, the exchange rate and interest rates. In most countries, central banks were
originally regular commercial banks that were granted by governments exclusive rights
to issue bank notes functioning as legal tender. Central banks became responsible for
controlling the supply of national currency they issued, since excessive growth of
money supply would result in inflation.18
The main goal of central bank’s monetary policy is the control of inflation. In most
developed countries the inflation goal is set at about 2,5% or less. In some countries,
central banks have an additional goal of supporting economic growth.
Inflation is a direct result of growth of money supply in economy. Since commercial
banks increase amount of money in circulation by lending out deposits, central bank
cannot control money supply directly, and it uses a set of methods to influence lending
by commercial banks. These methods include: open market operations, reserve ratios
and discount rates.19

1.4.1.1 Open market operations

Central bank can influence lending by banks through trading government securities with
commercial banks. If it wants lending (and monetary supply) reduced, it sells securities,
thus “blocking” some bank deposits for lending. Buying treasury securities from banks

18
Rothbard M. 1983, The Mystery of Banking, Richardson & Snyder, pp. 110-115.
19
Heffernan S. 2005…, op.cit., pp. 29-32.

14
has the opposite effect. The securities traded in these operations are short term treasury
bills. Sometimes central bank would issue its own bills and sell them to banks to reduce
monetary base. Apart from outright sale or purchase, central bank can enter into a
repurchase agreement with a commercial bank. Central bank can buy t-bills from a
bank, and then sell them back at a specified date (called repo) or do the opposite – sell
and buy back (called reverse repo).20

1.4.1.2 Discount rates

Each central bank controls a set of interest rates that are intended to guide rates in the
interbank. Increasing rates makes loans more expensive, and reduces money circulation.
Usually, a central bank would set three basic rates: reference rate, discount rate and
deposit rate21:
• Reference rate is a central bank’s main rate, set as the target for short-term
interbank rates. In USA, the target rate is the Federal Funds Rate. It is the
overnight rate, at which banks lend to each other the funds they have deposited
in the Federal Reserve in order to meet the required reserve ratio. In Europe, the
main refinancing rate is used for reference. It is the minimum bid rate for
refinancing bank loans at Central bank.
• Discount rate is the rate charged to banks when they borrow from central bank.
In US, there’s a primary and secondary discount rate, available to banks
depending on their credit worthiness. It is set higher than the reference rate,
since Central bank prefers that banks borrow from each other instead. By
lending funds to commercial banks, central bank exerts its function of lender of
last resort. In EU, this rate is called the marginal lending rate.
• Deposit rate (in Eurozone) is the lowest of the three. It’s the rate that banks
receive for deposits at the central bank.
Historical ECB and Fed rates are presented in the tables below:

20
Rothbard M. 1983…, op.cit., p. 95-99.
21
http://en.wikipedia.org/wiki/ 2008.XI.23, Central bank – Interest rates.

15
 Date of Deposit Main Marginal
change rate refinancing lending
rate rate
2009-01-21 1,00% 2,00% 3,00%
2008-12-10 2,00% 2,50% 3,00%
2008-11-12 2,75% 3,25% 3,75%
2008-10-09 3,25% 3,75% 4,25%
2008-10-08 2,75% 4,25% 4,75%
2008-07-09 3,25% 4,25% 5,25%
2007-01-13 3,00% 4,00% 5,00%
2007-03-14 2,75% 3,75% 4,75%
2006-12-13 2,50% 3,50% 4,50%
2006-10-11 2,25% 3,25% 4,25%
2006-08-09 2,00% 3,00% 4,00%
2006-06-15 1,75% 2,75% 3,75%
2006-03-08 1,50% 2,50% 3,50%
2005-12-06 1,25% 2,25% 3,25%
Table 1: Historical ECB interest rates, 2009.II.17, www.ecb.int

Date of Federal Discount Rate - Credit:

change Funds Rate Primary Secondary
2009-01-16 0,25% 0,25% 0,75%
2008-12-16 0,25% 0,50% 1,00%
2008-10-29 1,00% 1,25% 1,75%
2008-10-08 1,50% 1,75% 2,25%
2008-04-30 2,00% 2,25% 2,75%
2008-03-18 2,25% 2,50% 3,00%
2008-03-16 3,00% 3,25% 3,75%
2008-01-30 3,00% 3,50% 4,00%
2008-01-22 3,50% 4,00% 4,50%
2007-12-11 4,25% 4,75% 5,25%
2007-10-31 4,50% 5,00% 5,50%
2007-09-18 4,75% 5,25% 5,75%
2007-08-17 5,25% 5,75% 6,25%
2006-06-29 5,25% 6,25% 6,75%
2006-05-10 5,00% 6,00% 6,50%
2006-03-28 4,75% 5,75% 6,25%
2006-01-31 4,50% 5,50% 6,00%
2005-12-13 4,25% 5,25% 5,75%
Table 2: Historical Fed interest rates, 2009.II.17, www.newyorkfed.org
Some central banks set more interest rates, used for various transactions with banks.
The most typical transactions include lending funds to banks with various securities
deposited by them as collateral or buying trade bills and other commercial securities
from banks at some discount.
Central bank rates usually concern commercial banks only indirectly, as a point of
reference for interbank rates. However, in specific market conditions, e.g. when there is
a lack of liquidity in money market, banks tend to deal directly with the Central bank,
instead of trading among themselves. In these situations, discount rates illustrate real
costs of funding and should be included in the calculation of transfer prices.

16
1.4.1.3 Reserve ratios
In most countries, it is obligatory for commercial banks to hold a specified percentage
of their customer deposits and notes as cash or as deposit at the central bank. This
percentage is the reserve ratio which can be used by central bank as a tool of monetary
policy. Increasing the ratio limits lending by banks, and reduces money supply. There
are differences in the use of reserve ratio between countries22:
• In USA, the reserve ratio of 10% (3% for smaller or even zero for very small
institutions) concerns transaction deposits, while savings accounts and time
deposits have no reserve requirements. Beginning October 2008, Fed pays
interest on reserve balances. As of 11 February 2009, the interest rate equals
0,25%;23
• In UK, there is no required reserve ratio and banks hold a voluntary cash
reserve. From 18 May 2006, the Bank is paying interest on commercial bank
reserve balances. As of 5 February 2009, the Bank Rate paid on reserves equals
1,0%;24
• In the Eurozone, banks keep 2% of specified short-term liabilities at Central
bank, and receive interest based on the average rate of one week bills issues,
which currently (in February 2009) equals 2%;25
• In Poland, the ratio is 3,5%, and pays interest based on one of the Central bank
rates (rate at which central bank buys trade bills from commercial banks). The
interest paid on reserves currently (from 28 January 2009) equals 4,05%;26
• Many central banks (e.g. Bank of Japan) pay no interest on reserve balance,
however recently more and more banks have decided to pay for commercial
banks’ reserves due to the financial crisis.
The part of deposits that commercial banks need to keep in reserve cannot be used to
generate loans. Thus, total gain on a deposit gathered is reduced by the amount needed
for safekeeping. Therefore, the reserve ratio is included in the transfer price formula, to
reflect that internal income reduction.

22
Matthews K. & Thompson J. 2005, The economics of banking, John Wiley & Sons, pp. 53-54.
23
www.federalreserve.gov 2009.II.17, Monetary policy –required reserve balances.
24
www.bankofengland.co.uk 2009.II.17, News Release - Bank of England Reduces Bank Rate
25
www.bundesbank.de 2009.II.17, Minimum reserves
26
www.nbp.pl 2009.II.17, Basic interest rates

17
2 Financial markets and risks

2.1 Financial markets

In general, financial markets are places where various financial instruments are traded.
There are many typologies of markets, but the most common classification is by the
traded instrument type. Commercial banks are mostly active on markets in order to
hedge financial risk they encounter. When financial institutions buy and sell financial
instruments among themselves, they usually do it on markets, that are wholesale
(minimum transaction volume is hundreds of thousand USD or EUR) and OTC (over-
the-counter, where the majority of transactions are concluded directly, without a
clearing house). The most important instruments traded are: interbank loans and
deposits, government bills and bonds, foreign exchange, interest rate and currency
derivatives. Most instruments can be traded either in the money market (for securities
maturing in less than a year) or in the capital market (for instruments with a life longer
than one year). The central bank participates in most of these markets, in order to attain
monetary policy goals.
In this chapter the concepts of financial markets and risk management will be discussed.
Prices on interbank deposits, treasuries and interest rate derivatives can all be expressed
in the form of a rate. This rates show what is the cost or gain of lending and borrowing
on wholesale markets as compared to dealing with individual customers. Market rates
are used in the construction of transfer prices as a reference point for setting interest on
bank products.
The second part of the chapter deals with various types of financial risk, which is
relevant to transfer prices in a number of ways. Basically, each risk involved in a
customer transaction should be taken into account when pricing products. There are
different ways of incorporating risks in FTP system according to its type.

2.1.1 Interbank deposit market

When a bank has excess short term cash it would usually seek a counterparty that needs
short term funding (e.g. in order to meet reserve requirement) on the interbank deposit
market. This is the main market for bank liquidity management. The lender of funds
requires compensation in the form of interest on the capital lent. The interest rate on a
particular transaction depends on a number of factors, including: transaction length,

18
whether the bank is a lender or a depositor, partner’s credit risk, etc. Banks that
participate in the market constantly quote interest rates that they offer to depositors
(BID) and lenders (ASK), for various maturities. A bank hopes to pay BID rate on funds
that other banks deposit with it, receive a higher ASK rate on funds it loaned out, and
profit from the BID-ASK spread.
Interbank rates are largely dependant on Central Bank rates, which are meant to set
boundaries for interbank trading. In general, interbank rates should vary somewhere in
between central bank offer and bid rates. The idea is that depositing money with central
bank and borrowing from it should be the least profitable option a commercial bank has
on the market.
Financial market rates constitute the basis of each transfer price formula, as they express
the opportunity cost of transactions with customers. Market rates set boundaries for
lowering rates on loans an increasing interest on deposits offered to the public. A bank
should not pay more for customer deposits than it costs to raise funding from other
banks. This relation is analogical to the one a bank has with its central bank – trading
with central bank is less profitable than with other banks, and trading with other banks
is less profitable than dealing with customers.
There are different interbank rates to choose from when building the transfer price
equation. The choice should generally depend on actual transactions a bank can make –
i.e. it is preferable to use rates from the markets that a bank most often uses for
wholesale loan and deposit transactions.

2.1.1.1 Interbank interest rates

Interest rates vary depending on the date on which the transaction is to be concluded.
This time structure of interest rates can be represented on a time scale as a curve with
either upward or downward slope, showing rates that rise or fall with increasing length
of deposit. The difference between short-term and long-term part of the slope is most
commonly explained by the expectations theory as the expected change of interest rates
in future (e.g. a downward slope predicts falling rates). Another factor influencing the
curve is the liquidity preference, meaning that with increasing loan term, the lender
requires higher interest due to increased risk (the result would be an upward slope).
The time scale of the curve consists of specific nodes, i.e. lengths of deposits that are
most typical for the local interbank market. This set of time knots usually consists of the
following lengths:

19
 • O/N – overnight, a deposit starting today and ending tomorrow,
• T/N – tomorrow next, starting tomorrow and ending the day after,
• S/N – spot next, starting the day after tomorrow for one day,
• SW – spot week, starting the day after tomorrow for a week,
• 2W – two weeks, starting on spot date (as all the following do),
• 1M, 2M, 3M, 6M, 9M – one, two, three, six or nine months from spot,
• 1Y – one year is usually the longest term available.
One year is the maximum term on the interbank market, since it is a money market.
Apart from the enumerated nods, other lengths are available is parties choose so, since it
is an OTC market. In such cases, rates for not standard maturities are set based on linear
interpolation of neighboring rates.27

2.1.1.2 LIBOR rates

Rates quoted by a particular bank depend on its liquidity situation – when in need for
financing, it would offer higher rates, than when having surplus funds. A small bank,
with liquidity issues and a low credit rating would have a lot higher rates than a big,
stable bank. The interbank rates differ therefore among banks, usually within limits set
by central bank’s deposit and discount rates. In order to have a benchmark rate,
independent of individual bank’s conditions, an average rate is calculated. This rate,
fixed once a day, is a mean of daily quotes of a few selected contributor banks, usually
the largest and most reliable ones in a given market. Everyday, the whole time curve of
rates can be calculated. There are separate rates for interbank deposits in each currency,
however reference rates on deposits in most important currencies are set in London and
called LIBOR rates (London interbank offered rate). There’s LIBOR GBP for pound
sterling, but also LIBOR USD for US dollar, LIBOR CHF for Swiss frank, LIBOR JPY
for Japanese yen. LIBORs are ASK (offer) quotes, and BID is usually calculated as 10
to 15 b.p. (basis points) less, basing on general market consensus, although in past this
spread was significantly wider.28

27
Choudhry M. 2001, Bond and money markets: strategy, trading,,analysis, Elsevier Butterworth-
Heinemann, pp. 17-34.
28
http://en.wikipedia.org/wiki/ 2009.III.15, London Interbank Bid Rate.

20
2.1.1.3 Alternatives to LIBOR
The LIBOR rates are the most common reference rate for various interbank
transactions, including derivatives. However, there are alternatives to LIBORs.
Since LIBORs are set in London, many countries with strong local financial markets
quote their interbank rates domestically. For example, EURIBOR rates for deposits in
Euro are set in Frankfurt. Many countries set some sort of domestic rate, e.g. in Poland
there’s WIBOR (Warsaw interbank offered rate). The importance of these local market
rates depends usually on the amount of deposits traded in local markets. If these local
markets are more active than markets for those currencies in London, the local rates
become a point of reference for a currency.
A specific situation exists in USA, since LIBOR USD is set abroad and concerns mostly
international cross-currency transactions. Domestically, USA banks use overnight
federal funds rate as a point of reference, as transactions with central bank are more
popular in USA than actual interbank transactions.29
Another popular rate in the US is the prime rate, which is a consensus rate at which
large US banks would lend money to their most favored customers.30
Another type of a fixing rate is the SONIA (sterling overnight interbank average, there
also EONIA for EUR and POLONIA for PLN). It is a mean of rates on actual
transactions that took place on a single day. Sometimes it’s a lot better approximation of
market conditions than LIBOR, which is a theoretical rate, established under specific
conditions, including high credit rating, a limited nominal of transaction, and a
straightforward deal. Banks with low ratings, entering a large amount transaction,
customized (e.g. a derivative) might find that LIBOR rates are irrelevant as a point of
reference for their transaction.

2.1.1.4 Long term interbank rates

LIBOR rates have a serious drawback – they are money market rates, ending at maturity
of one year. Fortunately, there are active interbank markets for interest rate derivatives –
FRAs and especially IRS. The latter are instruments that allow to exchange a series of
LIBOR rate payments for a number of payments based on a fixed IRS rate, during a
period from a year to ten and more years. Therefore, IRS rates can be added to the

29
Crouhy M. & Galai D. & Mark R. 2005…, op.cit., pp.125-149.
30
www.bankrate.com 2009.II.18, Wall Street Journal Prime Rate

21
interbank rates curve for nods above one year. These derivatives will be described in
more detail in the chapter on interest rate risk.
The table below presents different interest rates with a term structure for a number of
currencies:

Table 3: Current market interest rates, 2009.II.18, http://markets.ft.com

2.1.2 Government debt markets

Apart from dealing in interbank deposit market, commercial banks are active traders of
government securities. These papers are issued to finance budget deficit and are sold at
auctions, usually at a discount to their nominal value. Later on, these securities are
traded on the market, mostly over the counter. At the redemption date, they’re redeemed
in full nominal value. Governments issue the following securities:31
• bills – with maturities from one to twelve months, paying no coupon, sold and
traded at a discount to nominal;

31
Choudhry M. 2001…, op.cit., pp. 203-271.

22
 • notes and bonds – with maturities from two to ten and more years, usually
offering a coupon, sold at a price close to nominal, trading according to market
prices. Coupons can be fixed or float and are usually paid every six months.
Some bonds have no coupon (zero-coupon), similarly to bills.
Government securities prices can be also expressed as yields. Using the internal rate of
return methodology, a yield to maturity (YTM) of a bond can be calculated. YTM is the
rate of discount that equates all the bond’s cash flows with its current price. A
government securities yield curve can be calculated for maturities from 1 month to 10
years, and can be an alternative to the interbank rates curve.32
However, the instruments underlying those two curves have different purposes – while
government securities are a mean of investment, interbank rates are a basis of a
multitude of transactions, including derivatives. Securities are used by banks to lend
money, not to borrow, although it is somewhat possible through the use of repo
(repurchase) deals in the form of Sell-Buy-Back transactions. In general, LIBOR rates
are a better point of reference for most bank transactions.

2.2 Managing risks

Asset transformation results in various types of financial risk being transferred from
customers to the bank. The tree main types of bank risk are:
• Credit risk,
• Interest rate risk,
• Liquidity risk.
• Currency risk.
The latter three are altogether described as the components of market risk. All of the
above-mentioned risks are related to FTP.
Interest risk is the one that is estimated by the rate used in the transfer price formula. It
is necessary to estimate interest risk profile for all bank products in order to choose the
most suitable transfer price equation for each of them.
The effects of interest, currency and liquidity risk on bank’s balance sheet (BS) and
profit and loss account (P&L) are singled out by FTP methodology in the management
accounting approach, facilitating risk management. Interest and currency risk

32
Ibidem, pp. 102-144.

23
management includes derivatives. Their introduction in the thesis is necessary, as they
are also priced by FTP as any other bank product.
Liquidity risk, interpreted as the risk of funding costs being in excess of market rates, is
directly included in transfer prices in the form of additional margin.
Credit risk is generally relevant to FTP, as it needs to be incorporated in prices for
products. It shows that, as a way of setting a minimum profitability level for products,
transfer prices are not always enough and other factors – like credit risk – should be
taken into consideration in the management accounting approach.

2.2.1 Credit risk

Credit risk is a result of information transformation function. Incomplete information on
borrowers requires appraisal and monitoring of risk of borrowers not repaying their
loans. To reduce that risk, banks require collateral on loans. Apart from individual loan
security, risk transformation includes risk diversification due to a large number of
borrowers.

2.2.1.1 Individual risk

Individual credit risk is the possibility of a counterparty not being able to comply with
his contractual obligations, e.g. a borrower not repaying a loan, or delaying principal or
interest payments. Different customers generate various risk types: consumer, corporate
or country risk, which can be subsequently divided to loan type:
• Individual consumer loan risk is evaluated through the use of credit scoring
models. The outcome of such models shows personal risk levels, allowing the
bank management to decide whether to give the loan or not, and how to price its
risk in the level of interest required. Some consumer loans usually have
collateral, e.g. mortgages are secured by property. Collateral is a supporting
source of cash in the event of loan being not repaid. 33
• Corporate loans risk appraisal resides mostly on ex ante analysis and ex post
monitoring. Prior to giving loans, thorough analysis of financial statements,
financial ratios and business plans is conducted using advanced models. For
large companies, credit ratings are issued by international agencies, facilitating

33
Lawrence D. & Solomon A. 2002, Managing a Consumer Lending Business, Solomon Lawrence
Partners, New York, pp. 43-60, 193-205.

24
 the risk assessment process. Loan contracts often include covenants –
restrictions put on borrowers’ activities that could increase credit risk, e.g.
excessive borrowing. Corporate risks also include the risk of other financial
institutions as counterparties in different financial instruments. 34
• Country risk is the risk of a government not repurchasing debt securities at their
maturity. However, country risk influences also risk of all companies from that
country. It is measured by rating agencies.

2.2.1.2 Portfolio risk

Credit risk can be limited by ensuring that the loan portfolio adheres to exposure
limitations. Limits include: concentration on a single customer or customer type,
geographic limits, economic sector limits, loan category limits, etc.
After the loan is given out, credit risk is managed on the portfolio level. The
management comprises monitoring the portfolio characteristics and identification of
nonperforming loans. In general, these are loans on which principal or interest payment
is overdue for a specified period of time. Also, loans with potential weaknesses are
sometimes taken into consideration. There are legal requirements for banks to set up
provisions for underperforming loans. The level of these provisions varies according to
legal regulations adopted in specific countries. Up till recently, all loans where divided
into several categories based on payment delay and debtor’s financial situation, and a
specific level of provisions for each category was required: 35
• Standard loans with satisfying performance were assigned a 1-2% level of
provisions (varying from country to country);
• Watched loans with very little delay or with slightly deteriorating financial
situation of the borrower - 5-10%
• Substandard loans – unsettled for less than 90 days with borrower’s cash flows
diminishing dangerously – 10-30%
• Doubtful – less than half a year past due, with questionable repayment – 50-75%
• Lost – overdue for more than half a year or considered uncollectible – 100%

34
Altman E. 1968, ‘Financial Ratios, Discriminate Analysis and the Prediction of Corporate Bankruptcy’,
Journal of Finance, vol. 23(4), pp. 589 – 609.
35
Glantz M. & Mun J. 2008, The Banker's Handbook on Credit Risk: Implementing Basel II , Elsevier,
pp. 8-34.

25
Recently, with introduction of new International Accounting Standard in 2005 and with
Basel Committee second recommendations, European banks are required to implement
models in order to estimate losses from impaired loans (incurred and expected) in the
form of discounted value of cash flows from those loans.36
Despite those changes, the basis remains the same – provisions are recognized on a
portfolio of loans according to their performance. The total level of provisions,
compared to the total portfolio of loans, indicates the total credit risk accounted for by a
bank. It can be expressed as a percentage ratio, quantifying the average risk of loans.
Therefore, interest rates on various loans should be sufficient to cover probable losses.37

2.2.2 Liquidity risk

Liquidity risk is the result of maturity transformation. It emerges because loans, in
principle, last longer than deposits. Depositors typically require direct access to their
funds, meaning that they agree to lend money to the bank for short term, fearing they
wouldn’t be able to use their funds when needs arise. In contrary, borrowers need long
term funding - for a few years in case of commercial loans, or for a few dozens of years
with housing loans. The consequence is the liquidity risk - meaning the maturity
mismatch between assets and liabilities. This entails a risk that the bank will not be able
to fulfill its current obligations. The maturity mismatch effect on bank’s P&L can by
measured using FTP methodology.
Liquidity risk measurement aims to estimate the actual cost of market funding, which
can sometimes differ from market rates. This extra liquidity cost can be included in the
transfer price formula, in order to reflect current market conditions faced by a bank.

2.2.2.1 Measurement of liquidity risk

Several measures can be used in order to identify liquidity risk. The most basic measure
(used by regulators) is the ratio of liquid assets compared to liquid liabilities, which
should be greater than one. This static measure can be enhanced by analyzing all assets
and liabilities in terms of their time structure. An analysis of contractual payments of
interest and principal on loans and deposits, divided on a time scale according to their

36
Witzany J. 2005, ‘The problem of conflicting standards’, Czech Business Weekly X.2005.
37
Glantz M. & Mun J. 2008…, op.cit., pp. 8-34

26
maturity, allows to determine whether at a given moment there is a lack of liquidity.
This analysis can be improved by assuming different scenarios of liquidity needs.

2.2.2.2 Short term liquidity management

Liquidity management aims at matching the maturity structure of assets and liabilities.
In a perfect situation, there are enough assets in all segments of the liquidity time scale
to cover liabilities, however this rarely takes place. The basic management approach is
to maintain surplus liquid assets in the form of a marketable securities (preferably
treasuries), in order to sell them should unforeseen liquidity needs arise. Regulators
favor that method, setting minimum liquidity requirement as a ratio of liquid assets to
total assets.
Everyday liquidity management takes the form of short-term money market borrowing.
In USA, central bank and security trading are more popular sources of funds than
interbank loans, as is the case in Europe. However, financing liquidity needs in the
interbank market carries some risk. Although official rates (e.g. LIBOR) are known, the
cost of liquidity for a specific bank can differ due to a number of factors. A small bank,
with a low standing, having solvency issues can be unable to obtain liabilities at a
reasonable price, expressed as a spread to LIBOR rates. In times of market liquidity
crisis, funding might be unavailable at all. Central bank, as the lender of last resort,
would usually help out in such cases, though at prices significantly higher than the ones
prevailing in the interbank market. Taking into account market and individual
conditions, a bank needs to determine its specific marginal cost of money market
borrowing.38

2.2.2.3 Long term funding management

Due to the potential money market liquidity shortage, long term financing is preferable.
In general, financing long lasting assets with liabilities of short maturity causes a risk
that rates on deposits will be unfavorably reset, while interest on loans will remain
unchanged. While ad hoc liquidity management comprises of selling liquid assets and
borrowing on money market, long term liquidity management focuses mostly on

38
Greuning H. & Bratanovic S. 2003, Analyzing and Managing Banking Risk. The World Bank,
Washington, pp. 167-190.

27
ensuring stable funding. In a bank, this task is assigned to a committee named ALCO
(Asset and Liabilities Management Committee).39
ALCO can manage liquidity through the use of capital markets, either on liabilities side
- by borrowing from financial groups, issuing debt securities and increasing capital – or
on assets side – by selling or securitizing some loans to free funds. Moreover, ALCO
can manage all balance sheet items by altering product pricing. Increasing interest rates
on products offered to customers affects the level of sales, resulting in restricting loan
expansion and encouraging growth of deposits if necessary. To do so, ALCO is
equipped with special tools, allowing it to manipulate internal product profitability.
These tools comprise liquidity margin, which can be added to transfer prices to reflect
current cost of market financing, and other margins, applied in order to regulate sales of
single products.40

2.2.3 Interest rate risk

Interest rate risk is the main risk that a commercial bank is exposed to, since bank’s
activities as intermediaries between customers and financial markets result in creating
assets and liabilities with incompliant interest rate characteristics. Various bank
products and elements of balance sheet receive or pay interest based on different
conditions. Rates can be fixed during the life of a transaction or flexible – where the rate
is reset, either at periods of time specified ahead or at managements’ discretion.
Interest rate risk results from unequal elasticity of assets and liabilities rate adjustment
to market rates. For example, if assets’ elasticity is higher than that of liabilities, and
market interest rates decrease, average rates on loans fall more than interest paid on
deposits, resulting in diminishing net interest income.
Estimating interest rate elasticity and resetting profile for all bank products is necessary
to select relevant transfer price. Not all products have simple LIBOR + margin interest.
Non-market interest products require an estimate of their repricing characteristics.

39
Alexandre A. 2007, Handbook of Asset and Liability Management: From Models to Optimal Return
Strategies, Wiley Finance, pp.83-99.
40
Ibidem, pp.203-220.

28
2.2.3.1 Measuring interest rate risk
The most basic method of measuring interest rate risk is the gap analysis. In this model,
all the assets and liabilities are put on a time scale, which is divided into time periods
(e.g. into months below one year, and into years above). A loan or deposit is allocated
to a period based on the time, when its interest rate is repriced. After all the products are
divided according to the time interval when their rates may change, the difference
between assets and liabilities in each segment is calculated. If this result is positive,
more loans than deposits reprice in the specific timeframe, resulting in positive
correlation of rate increase and interest income. When the gap is close to zero, interest
risk is minimized. Cumulative gap is the sum of all individual gaps for different time
periods. To show impact on interest income, the gap can be multiplied by the rate
change. The gap analysis should be enhanced by measuring the elasticity of various
products within one time segment. The simple gap model assumes that when a
product’s interest rate is reset in a segment, it is reset by the amount that market rates
change. However, product elasticity can be different than one. Different loans and
deposits can have unequal level of reaction to market rate shifts. Even if the gap equals
zero, elasticity differences entail interest rate risk (e.g. an equivalent amount of assets
and liabilities reprices in a given time period; however assets have an elasticity of one
while elasticity of deposits equals one half).41
The gap method doesn’t account for a number of factors. First of all, it doesn’t consider
unparallel shifts in yield curve, where short term rates change differently than long term
rates. Moreover, as a static measure, it doesn’t account for basis risk – a risk that some
rates reprice on a different yield curve than the others do (e.g. some loans can be linked
to central bank rates, whereas most products are reset based on LIBOR rates). Finally, it
is a static method, and doesn’t include expected changes in balance sheet repricing
structure. Other methods overcome those disadvantages. Sensitivity analysis applies
different yield curve shift scenarios to the gap method. In more complex models, the
entire balance sheet is simulated and bank’s income sensitivity to various interest curve
changes is examined.42

41
Crouhy M. & Galai D. & Mark R. 2005, The Essentials of Risk Management, McGraw-Hill, New York,
pp.125-149.
42
Greuning H. & Bratanovic S. 2003…, op.cit., pp. 249-260.

29
2.2.3.2 Fixed interest income risk
A specific type of interest risk is linked with fixed income securities. Contrary to loans
and deposits, interest rate changes don’t influence their coupons but their value. The
effect is not on bank’s interest income, but on the value of its assets. Interest payments
on these securities are fixed throughout their whole lives, along with the final payment
of capital. The paper is priced as a series of discounted cash flows, where market yields
are used as a discount factor. When yields rise, the present value of future cash flows
falls, and the price of a fixed income paper reduces. Regular methods of risk
measurement and control are not well suited here, so other techniques need to be
employed. Duration is a measure of average time to maturity of a security (in years),
where all the discounted cash flows are weighted by the time remaining to maturity. To
determine an instrument’s elasticity to rate changes, modified duration is used. It is
expressed in percent of security price change due to a one basis point parallel change in
interest rates. In practice, instead of measuring percentage change, the absolute change
in price of a security (in USD or another currency) is measured, called basis point value
(BPV). Debt securities risk is managed through the use of interest rate derivatives -
FRAs and IRSs. Due to their price reaction to rates change, fixed income securities
always have negative BPV, whereas FRAs and IRSs have positive BPV. The total BPV
on a portfolio of debt securities and interest derivatives can be used as a measure of
interest rate risk and minimized.43

2.2.3.3 Managing interest rate risk

Interest rate risk can be managed by influencing the product structure. Changing
business strategies in order to limit sales of some products (e.g. fixed rate loans) and
promote others can result in long-term reduction of risk. Selling fixed-rate assets (e.g.
bonds) has similar effect. Limits can be set on exposures to interest risk, as a proportion
of bank’s income, capital or assets, further on divided by products or business units.
Most often however, especially when debt securities are involved, yield curve risk is
managed by the use of interest derivatives. As it was mentioned before, there are many
different interest rate derivatives traded by banks: forward rate agreements (FRA),
interest rate swaps (IRS), interest rate futures and options. FRAs and IRS are the most

43
Choudhry M. 2004, Advanced Fixed Income Analysis, Elsevier Butterworth-Heinemann, pp. 1-34.

30
widespread for risk management purposes. These instruments will be briefly described
below.
A FRA is an agreement where one party (long) agrees to pay a specified above rate, in
exchange for a floating market rate, which will be known in future. For example, in a
2x5 FRA a bank taking long position agrees to pay in two months a 3M LIBOR rate,
receiving at the same time a rate fixed today, which is the 2x5 FRA rate. Both rates will
be paid on an agreed nominal for a quarter of a year. There is only one cash flow – a net
of both payments, made in two months from now, however the amount to be paid and
the payer are unknown at the contract initiation. The most popular FRA agreements are:
for 1 month (starting in 1 or months), for 3 months (starting in 1, 2, 3, 6 or 9 months)
and for 6 months (starting in 1, 3 or 6 months).44
An IRS is a series of FRAs. The most typical IRS changes a fixed rate into a 3M or 6M
LIBOR. It can last from 1 to usually 10 years. A 1 year IRS based on 3M LIBOR is like
entering today a into a series of FRA (3x6, 6x9 and 9x12) and a 3 month deposit. The
first payment is known ahead, and equals the difference between the IRS rate and the
current 3M LIBOR. An OIS (overnight interest swap) is an IRS based on O/N LIBOR,
with everyday payments.45

2.2.4 Currency risk

Currency risk is another type of risk, faced by banks that operate in more than one
(domestic) currency. Even conservative commercial banks have such products - a
typical example is a loan denominated in a foreign currency which has low interest
rates. Currency risk exists when assets in a given foreign currency don’t equal
liabilities, or, more precisely, when cash flows in a currency don’t even out (e.g. interest
paid doesn’t equal interest received). This results in a currency gap, which influences
bank profits. This effect can be shown using FTP methodology. Currency risk
management requires using derivatives and pricing them with transfer prices is a
complex issue.

44
Hull J.C. 2006, Options, futures and other derivatives, Pearson Prentice Hall, New Jersey, pp.84-88.
45
Ibidem, pp.149-154.

31
2.2.4.1 Foreign exchange rates
Currency risk is a result of significant exchange rates variability. The value of the most
important currencies – US Dollar, Euro, UK Sterling, Japanese Yen, Swiss Franc – is
set on the market. Despite central banks’ interventions in defense of national currencies,
this can result in large fluctuations. Central bank announces official fixing rates daily,
based on prevailing market rates. However banks often quote more than one rate for
each currency. They announce different price for foreign deposits (BID) than for loans
(ASK), and profit from the spread between them. Moreover, exchange rates they offer
to individual customers are dissimilar (with a larger spread) from those applicable for
wholesale customers.

2.2.4.2 Currency risk measurement

Currency risk analysis and measurement is similar to interest rate and liquidity risk
measurement conducted for each foreign currency on bank’s balance sheet.
A so called net long or short position in foreign currency is the most widespread
measure. It is calculated as difference between assets and liabilities (and off-balance
derivatives) that mature in near future (e.g. a week), which can be further on divided
into maturity periods, similarly to gap analysis. Net position should be calculated in
each currency, and summarized, either as total of positive and negative positions, or as a
sum of absolute values, or as the greater of the aggregate short positions and aggregate
long positions.46

2.2.4.3 Currency risk management

Currency risk can cause very large losses for banks, therefore most commercial banks
seek to have zero currency risk exposure. As a basic tool of currency risk management,
limits are established for aggregate currency position – usually 10% to 15% of bank’s
relevant capital. Limits are also set on individual currency positions, most often
expressed as a maximum absolute value of mismatch during specific time periods – this
day, next week, next month, next half year etc. The net position for the next day or a
few is then closed on everyday basis on currency markets, with spot and forward

46
Greuning H. & Bratanovic S. 2003…, op.cit., pp. 261-270.

32
currency transactions. These transactions consist of simple currency exchange, either
immediately (spot) or on a future date, with an exchange rate set today (forward).47
Nevertheless, closing impending currency positions is not sufficient for liquidity
disparity. Just like funding long term loans with short term deposits entails regular
liquidity issues, funding loans in one currency with deposits in another one results in
long term currency liquidity issues. This is a popular case in countries with high interest
rates, where offering loans in currencies with low interest rates (JAP or CHF) is very
popular with customers. This discrepancy can’t be handled within everyday currency
position management, since interest paid in one currency is based on different rates than
the interest received in another currency. For example, funding LIBOR CHF loans with
LIBOR GBP deposits results in currency and interest risk combined. It is more suitable
to hedge such transactions against both types of risk at once with derivatives such as FX
Swap and CIRS. FX Swap (foreign exchange swap) is an instrument similar to a FRA,
except that instead of swapping fixed for floating payments, it exchanges payments
based on rates in different currencies. Likewise, CIRS (currency interest rate swap) is a
foreign exchange version of a regular IRS. Typical FX Swap and CIRS deals would
swap float for float, although fixed for float rate swap is also possible. More often than
not, these derivatives include initial and final exchange of nominal, necessary for
hedging currency risk.48
Using FX Swap and CIRS handles currency and interest rate risk, but not the liquidity
risk. This can be handled with regular liquidity management methods, however finding
long term funding for foreign currency loans might be impossible or very expensive,
and currency swaps with long term maturities might be unavailable on global interbank
market.

47
Ibidem, pp.271-280.
48
Brown K. & Smith D. 1995, Interest Rate and Currency Swaps, CFA Institute Research Foundation,
pp. 41-70.

33
3 Basic transfer pricing theory
The first two chapters presented the basic concepts in banking, including functions and
types of banks and the role of central bank. For each model of banking, different FTP
system is relevant. Further on, financial markets were described with emphasis on the
prevailing interest rates, which are most commonly the basis of transfer price formulas.
Next, the need for risk management, including interest and liquidity risk, was brought
into attention. The risks described are taken into account by the most sophisticated FTP
models.
This chapter introduces transfer prices and describes fund transfer pricing systems. First
of all, the need for and objectives of FTP are explained and transfer prices are defined.
Secondly, different FTP methodologies are presented, beginning with simple ones and
moving to the ones with increased complexity. Along with explaining methodology,
arising issues are outlined: the choice between one transfer price or many, calculating
TP internally or basing on market rates, using product pools or matching individual
transactions.

3.1 Introduction to fund transfer pricing

To begin with, it is necessary to understand the need for FTP, its objectives and its
definition, along with the definition of transfer price. This is the content of the
following subchapters.

3.1.1 The need for fund transfer pricing

Fund transfer pricing system in general allows the decomposition of interest income. As
shown in an exemplary bank’s income statement below, interest constitutes a large part
of a bank’s profit:

34
Table 4: UBS Q408 Financial Report – Income statement, 2009.III.09, www.ubs.com

Net interest income is the largest component of a typical commercial bank’s income
(followed by fees and commissions) and can constitute up to 80 percent of a bank's
revenue. On the income statement, this component is decomposed into interest income
and interest expense for the entire bank and no further analysis is available.49
Decomposition of net accounting interest result into products shows that all loans and
other assets generate interest income, while deposits and other liabilities carry interest
expense. Judging product effectiveness using this measure would result in evaluating all

49
Coffey J. 2001, ‘What is fund transfer pricing’, ABA Bank Marketing, vol. 33 issue 9.

35
loans as profitable and all loans as causing losses. This is simply wrong, since giving a
loan to customer requires funds that usually come from deposits placed by another
customer. Each deposit has a value to the bank as a source of loan activity, and each
loan bears the cost of using funds from that source. FTP puts an internal price on
deposits, deducted as cost from loans.
Not only does transfer pricing allow to calculate profitability of loans, deposits and
other products. It also enables measurement of interest income by branches, business
lines and customers. Measuring profits on different levels allows the internal
comparison of effectiveness, evaluation and appraisal.50
Monitoring the participation of different sources in the creation of overall profits is one
of the elements necessary to manage a bank. It allows to make rational decisions about
resource allocation, cost control and level of profitability. Information on product and
customer profitability creates the basis for pricing decisions, and indicates which
products and customers are the most cost-effective for the bank. Making sound business
decisions based on correctly calculated profitability becomes more important with
increasing competition in financial services and in the environment of low but highly
variable interest rates.51
Faulty FTP systems can even cause bankruptcy, as was the case of Franklin National
Bank and many other financial institutions in USA in the ‘70s.52

3.1.2 Definition and objectives of a FTP system

In short, a FTP system “measures the value of products furnished by a profit center to
other responsibility centers within a company. Internal exchanges that are measured by
transfer prices result in (1) revenue for the responsibility center furnishing (i.e. selling)
the product and (2) costs for the responsibility center receiving (i.e., buying) the
product.”53

50
Kocakülâh M. & Egler M. 2006, ‘Funds Transfer Pricing: How to Measure Branch Profitability’,
Journal of Performance Management.
51
Convery S. 2003, ‘Keeping banks competitive: a foundation for robust performance management’,
Balance Sheet, vol. 11 issue 3.
52
Deventer D. 2002, Transfer Pricing systems design: building clarity in the responsibility for and
measurement of risk, Kamakura Corporation, pp.1-6.
53
Anthony R. & Hawkins D. & Merchant K. 2004, Accounting Text & cases, McGraw-Hill, New York,
p.494.

36
Basing on the definition above and on the requirements enumerated in the previous
subchapter, a list of objectives of an FTP system can be built. A good FTP system
should enable the following:54
• Allocating interest margins to assets and liabilities, in order to reflect cost of
funding.
• Determining profitability of products and customers in order to boost changes
in assets and liabilities structure that lead to increased total profits. Transfer
prices set a minimum required level of profitability for products, indicating
which of them bring more gains to the bank.
• Evaluating business decisions in organization basing on the contribution of
branches and business lines to overall profits. To fulfill this goal, it is necessary
that decision makers are held responsible for the results that they are able to
control.
• Control of interest rate and liquidity risk by transferring it to the unit
responsible for interest rate risk management. Overall market risks can only be
effectively managed on the central level, by treasury department and by ALCO.
Some of these goals were mentioned above, other will be explained in more detail in
latter parts of the thesis, as various FTP methods are presented.

3.1.3 Defining transfer prices

Each fund transfer pricing system relies on transfer prices (TP). A transfer price is an
internal rate of interest used to calculate transfer income or cost due to an internal flow
of funds in a financial institution. It is very similar to actual rate of interest paid or
received on a bank product, since it concerns the same transaction balance that the
actual rate of interest does. As the actual accounting income received on a loan is
calculated based on the interest rate, the internal transfer expense is calculated using the
transfer price. For each loan, there’s a transfer cost, whereas for each deposit, there’s a
transfer income.
The difference between interest rate and a transfer price is the interest margin, which
allows to calculate the internal interest profit on a transaction. The actual method of
assigning TP to a loan or deposit depends on the choice of FTP methodology.

54
Kawano R. 2000, ‘Funds Transfer Pricing’, Journal of Bank Cost & Management Accounting.

37
3.1.4 Bank products
There are a number of FTP methodologies available with different level of accurateness
and complexity. These methods differ by their approach to transfer price calculation and
by the level of assets and liabilities (A&L) decomposition that they allow.
Each bank product has different interest rate characteristic and maturity characteristics,
that are the basis of assigning transfer prices. The most popular products, building up
most of an average commercial bank’s balance sheet are: consumer loan, commercial
loan, mortgage, credit card, line of credit, current account, savings account, term
deposit. They differ by their maturity (average life), repayment schedule, interest rate
type, etc. The table below presents the most typical characteristics of these products:
Product BS side Maturity Rate repricing
consumer loan asset 3mth-2yrs fixed/Libor/Internal
commercial loan asset 0,5-5yrs Libor
mortgage asset 10-30yrs fixed or Libor
credit card asset Unknown internal
line of credit asset Unknown internal
current account liability unknown +/- zero
savings account liability unknown internal
term deposit liability 1day-2yrs fixed or Libor
Table 5: Typical bank products’ characteristics.
As the table shows, loans and deposits can have different maturities – varying from
many years for a home mortgage loan, to even a day for an overnight term deposit.
Some products don’t have actual maturities, as their repayment doesn’t follow a set
schedule – e.g. funds on a current account are available to the owner at any point of
time. Moreover, interest on products can be calculated by many methods. Term deposits
can have a fixed rate, set at their origination and unchanged for their entire life. Many
commercial loans receive interest based on a market reference rate, e.g. LIBOR 1M,
which changes once every month for the whole life of the loan. Many products have
rates set internally by bank authorities. Rate on a transaction is then changed whenever
management decides to alter rates for the relevant product.

3.2 Single pool method

Out of many FTP methods created to allocate interest margin to bank’s assets and
liabilities the most basic one is the single pool method. This method treats all
transactions uniformly, putting them in one pool of funds. The providers of funds add to
the pool, and the users take from it. Under this approach, the same one and only transfer

38
price rate is assigned to all the loans and deposits. There’s no difference in pricing
products with various repricing and maturity characteristics.55
This is illustrated in the following graph using exemplary rates:

6%

4% -4%
6%

2%

0%

4% -2%

-2%
Loan -TP +TP Deposit

Graph 1: Transfer price in the single pool method.

3.2.1 Advantages and drawbacks of single pool

The single pool method is simple and easy to implement, without much investment in
data systems. It doesn’t require much know-how or buying expensive IT systems. In
fact, FTP calculations for this method can be done by one person in a spreadsheet.
Single pool allows for assigning average cost of funds to all transactions, giving a crude
estimate of product or branch profitability. It is good enough when a bank doesn’t have
detailed databases of transactions, and possesses product information only on balance
sheet level.
It is suitable for a small bank, with stable and undiversified sources of funds, financing
its loans with deposits only. Also, the bank should be operating as a single unit, without
many branches or business lines. Therefore it can be recommended for para-banks:
savings and loan associations or credit unions. However, even for those institutions,

55
Smullen J. 2001, Transfer Pricing for Financial Institutions, Woodhead Publishing, pp.59-65.

39
single pool should only serve as an initial FTP system, consequently developed to a
more detailed approach.
This method however has a number of drawbacks that make it obsolete for larger
commercial banks with various products. These disadvantages include the following:
• interest rate risk is not separated from credit risk and it cannot be transferred,
• single TP makes it impossible to create managerial incentives to attract deposits
without simultaneously providing disincentives to sell loans,
• a single rate values doesn’t allow to differentiate transfer results according to the
term structure of the portfolio,
• the method doesn’t take into account the historical interest rates prevailing at the
time of transaction origination,
• it doesn’t allow fair measurement of managerial results

3.2.2 Calculating internal transfer price

In the single pool method, the transfer price is usually calculated internally – as an
average interest rate on bank’s products. At the moment of calculation, all interest
received on loans and paid on deposits is weighted by their outstanding balance. The
resulting rate is a weighted average rate of interest of all banks A&L.
To calculate the transfer income or expense, the TP is the multiplied by product balance.
Different levels of product decomposition can be used for balance, either basing on BS
or customer’s account data. The balance can be calculated as a mean for a period of
time. The actual length of the period should equal the frequency of TP calculation,
which should be done repetitively, to account for interest rate variation.
Variations of average internal fund price calculation include computing it based only on
interest expense on deposits or only on interest income on loans. However, choosing the
mean deposit rate as the single TP favors loans (lower transfer expense) at the detriment
of deposits, whereas choosing the average loan rate would have the opposite effect.

3.2.3 Net or gross balance

Although the single pool method is very straight forward, it entails some issues and
dilemmas that can be solved in different ways. First of all, the single pool method can
be used on a net or gross basis for each branch or business line. It means that the

40
transfer of funds can be employed either to all the deposits and loans in the unit (gross
balance) or only to the net position of interest result.56
In the net balance approach, a branch that uses more funds than it provides is charged
only for the funds that it cannot rise by itself. This method relies on observation of the
actual transfer of funds from and to the branch. If a branch lacks some funding, the
central treasury department has to provide the financing, and invest the surplus in the
contrary situation. Treasury does it usually by moving funds between branches, using
the interbank market only as the last resort.
The gross balance method assumes that all the funds, not only the excess and lacking
ones, are virtually moved through the treasury department. As a result, all the
transactions are priced within the FTP system, contrary to only some in the net balance
method. The gross methodology, although not reflecting real flow of funds, is
preferable, since it allows better estimate of branch profitability and treats all
transactions equally, disregarding the current net A&L position in the branch.

3.2.4 Double pool method

As it was written above, the internal TP can be calculated basing on all products, or
only on loans or deposits. Calculating the latter two rates allows a modification of the
method by dividing the single pool into two separate pools. In the double pool method
(also called split pools), loans are attributed the average loan rate, and the mean deposit
rate is used as the TP for deposits. This approach allows better product profitability
evaluation. Since all new deposits are valued in comparison to the current deposit
portfolio, only the ones that increase overall profitability of deposits are attributed a
positive interest margin.57
However this modification causes an imbalance between managerial and accounting
results. The difference between TP for assets and deposits called the spread isn’t
attributed to any product, therefore it should be classified to a distinct FTP portfolio.
This is represented in the graph below, which is a slightly modified version of the
previous one:

56
Kawano R. 2005, ‘Funds Transfer Pricing’, Journal of Performance Management.
57
Early B. 2005, Banker’s Guide to Funds Transfer Pricing, Sheshnuff, p.64.

41
 6%

4% -4%
6%

2%
1%

0%

3% -2%

-2%
Loan -TP FTP spread +TP Deposit

Graph 2: Transfer price in the double pool method

Adding more prices that differ not only by BS side, but also by repricing characteristics
and term structure of products, leads to a multiple pool methodology, which increases
the size and complexity of FTP portfolio.

42
4 Multiple pool method
Under multiple pool approach, all products are divided into a number of pools, divided
by different criteria. Most often the criterion is to aggregate products based on their
original maturity or repricing term. Additional factors may include product type and
other attributes. Each pool covers a single part of the maturity spectrum, and their
number are span depends on individual bank’s balance sheet term structure.
The bank establishes a set of transfer rates, assigning to products in each term segment a
different interest rate. Under this approach, the difference between term structure of
assets and liabilities is added to the FTP portfolio.

4.1 Market transfer prices

Instead of one or two transfer prices, a whole set of rates is needed under the multiple
pool approach – one price for each pool. These can be derived internally, just as for
single and double pool, by calculating average interest rate on assets and deposits in
each pool. However, this approach lacks objectivity, and doesn’t encourage correct
business decisions. A much better method is to base transfer prices on market rates.
This approach is specifically suitable for banks that actively trade in the interbank
market. For them, transfer prices determined in this way represent a source of income or
cost alternative to dealing with customers. This concept reflects actual transactions –
instead of taking in deposits from customers, a bank can borrow funds on the market.
For each client transaction there’s an alternative in the form of interbank transactions.
At any point of time, the rates prevailing in the market should be accepted as the cost of
funds suitable for the bank.58
Applying market-based transfer prices provides the most methodologically consistent
results, based on objective external criteria. Market rates allow objective verification of
product pricing policy, they are also a good mean for evaluating management
performance. Transfer prices should reflect market rates on instruments such as
treasuries, interbank loans or interest rate derivatives. The bank must establish a set of
transfer rates in the form of a yield curve that most accurately reflects its market cost of

58
Coombs H. & Hobbs D. & Jenkins E. 2005, Management Accounting: Principles and Applications,
SAGE, pp.316-324.

43
funds. Most banks use the LIBOR/Swap curve, as it is built of instruments they most
actively trade in. 59

4.2 Building pools of transactions

The above-mentioned rate curve shows the relationship between maturity and interest
rate, as it was described in the chapter on financial markets. In multiple pool method,
instead of two TPs as in double pool, there are two transfer price curves used – one for
assets and another for liabilities, depending on their interest rate repricing characteristic.
Pools are created of transactions with similar customer interest rate characteristics. The
typical pool-building process is conducted on three levels – product, rate characteristic
and currency. To each pool a rate from a LIBOR/Swap curve for a given currency is
appointed. These curves are presented in the graph below, along with the transfer price
selection process:

6%
- defined or unknown mat. - 3M to many yrs mat. - many years maturity
- internal interest rate - 3M floating rate - fixed interest rate
5% - eg. consumer loan - eg. float mortgage - eg. fixed mortgage

- unknown mat & residue

4%
- internal interest rate
- eg. current account

3%

- 1-2 years maturity

2% - fixed interest rate
- 6M to many yrs mat. - eg. fixed term deposit
- 6M floating rate
- eg. commercial loan
1%

0%
O N

M
1M

3M

6M
1W

2Y
/

12
O

S
R
R

R
O

IR
O

O
B

B
B
B

B
LI

LI

LI
LI
LI

LI

Graph 3: Assigning transfer prices to multiple pools

The graph shows curves for the domestic currency, curves for any currencies that make
up a significant part of portfolio need to be built. For the currencies with a small share
of transactions, the main currency curves can be used.
Rates from the curve are assigned to loans and deposits basing on the pool they are in.
A loan that has a longer maturity would be assigned a higher transfer price under a

59
Rice J. & Kocakülâh M. 2004, ‘Funds Transfer Pricing: A Management Accounting Approach within
the Banking Industry’, Journal of Performance Management, vol. 17 issue 2.

44
normally shaped rate curve. As shown in the graph, pools are constructed for typical
product categories, according to their interest rate type and maturity. Typical product
pools are listed below.

4.2.1 Long term fixed rate products

Products with long term (LT) fixed rates – e.g. fixed rate mortgages - are difficult to
model under multiple pool methodology, as their rate structure is very inhomogeneous.
Products with a rate fixed for a year or two – e.g. long term deposits – are easier to
replicate. A rate from swap curve is assigned, from a point that is close to average time
to maturity of transactions in a portfolio. It can be assumed for a portfolio of
transactions that have been sold in similar numbers for an amount of time, that the
average maturity equals half of the original term. E.g. a pool of two year fixed rate
products can have a LIBOR 12M rate assigned. For the two years deposit pool, the
average time (assuming constant sales structure) to maturity would be one year, as the
transactions in the pool can have current maturities ranging from a day to two years.
There can be a number of fixed rate portfolios, each for transactions of different length
for a given product.

4.2.2 Float and internal rate products

Short term (ST) products with fixed rate (e.g. monthly deposits) and products with long
maturities but with float rates can be treated uniformly. E.g. mortgages with interest
based on a 3M LIBOR will have the same repricing characteristics as a pool of 3M
deposits. Pools with rates from 1M to 9M can be created, according to their term
characteristics.
Many bank products have rates set by management. Products with such an internal rate
need to have a proxy market rate assigned, basing on predicted bank rate alteration
frequency. This rate is set at discretion of management, basing on business conditions –
such as level of sales – and on external environment – i.e. market rates or, most often,
official central bank rates. Decisions to keep or change rates are usually made in
monthly cycle, so for products with internal rates and with maturities above a month,
often a 1M rate is assigned. Basing on historical frequency of internal rates alteration,
another period length can be assumed.

45
4.2.3 Blended term for indeterminate maturity products
When the internal rate is combined with very short or unknown maturity – as for current
accounts or credit cards – TP can be assigned as in the previous example, based on a
single rate, usually 1M. Sometimes, a shorter rate is appointed, due to interpreting
unknown maturity as being a very short one. However, the most popular approach is to
divide each product with unknown maturity into two or more maturity layers each
assigned a different average rate. The overall pool rate is then blended from all the rates
on different pool layers. E.g. in current account pool, funds from many accounts are
withdrawn on any given day, however, there’s always some amount of funds left in the
whole pool. In other words, the sum of money deposited in accounts varies, but it
doesn’t fall below a certain minimum level. This minimum level of funds, different for
each product in each bank, can be calculated based on historical data. This residual
amount is then treated as a subpool with a maturity of a year or even longer, whereas the
fluctuating part of the portfolio is priced with weekly or even daily rates.60
This residual subpool is represented in the graph:

100%

80%

60%
% of pool

40%

Fluctuating subpool - O/N rate

Recalculated residual subpool
20%

Residual subpool - 12M rate

0%
0 30 60 90 120 days 150 180 210 240

Graph 4: Residual subpool estimation.

As the residual level of deposits changes, the size of the subpool (expressed in percent
of total portfolio) needs to reestimated. More than two subpools can be employed,
representing layers with different volatility characteristic in the pool. The average of

60
Bowers T. 2006, ‘Transfer Pricing Indeterminate-Maturity Deposits’, Journal of Performance
Management.

46
rate terms of all subpools, weighted by their size, is used as a proxy for the pool
maturity.

4.3 Calculating transfer rates

The transfer price assigned to each pool is based on its maturity and on market rates
prevailing for its term. For assets which bring interest income the TP is negative in
order to calculate a cost of funds. For liabilities bearing interest cots the TP is positive,
showing the internal income attributed to funds raised. However, since market rates
vary constantly, transfer prices for the pools need to be changed from one period to
another. First, the length of this period needs to be determined.

4.3.1 Price period length

There’s actually very little diversity in the choice of transfer price alteration frequency
period. Usually, monthly periods are used for market price calculation, since internal
reporting on managerial results is commonly conducted on monthly basis. External
accounting reporting is most often conducted quarterly, but TP are not involved in
external reports. The price can be calculated based on average daily TPs in a month;
however, shorter periods can also be employed. Instead of calculating average monthly
price and multiplying it by average monthly pool balance, daily prices and daily pool
balance can be used. This approach adds accuracy to the pool model and should be
implemented if data allows it.

4.3.2 Ex post or ex ante prices

Calculating average TPs for a pool should always be done with one goal in mind – the
best approximation of customer interest rates in that pool.
There are two ways to approach that subject:61
• One is to assign ex ante rates to transactions – the ex ante rates are set for a
month ahead basing on current or historic rates. For business units, knowledge
of the transfer price at the time of transaction is important, as the management
can then make a correct business decision. They know how much interest they
need to “charge” customer for a loan in order for the transaction to be profitable.

61
Emmanuel C. & Gee K. 1982, ‘Transfer Pricing: a fair and neutral procedure’, Accounting and
Business Research, vol.3 (Autumn), pp.273-278

47
 However, under pool methods, rates are recalculated each month, and the rate
for the loan will be changed next month. So, under the ex ante approach in
multiple pool method, the rate on the loan will be known ahead for the first
month only, then TP will be reset for the whole pool. Since most bank products
last longer than one month, there’s little gain from using ex ante prices to the
quality of management decisions.
• Another method is to assign ex post prices. In this method, the prices are
calculated after the end of a month. The TPs are therefore unknown at the time
of sale, which is a drawback. However, there’s a significant advantage, that the
ex post price is a better approximation of actual market rates prevailing at the
time of transaction. Since ex ante prices last only during initial month, the ex
post method is preferred under multiple pool. Business units don’t know the TP
on their loans when they sell them, however they can check current market rates,
and, knowing the formula for determining the price, they know what average
rates on loan pool are to be expected.

4.3.3 Weighted moving average methodology

After deciding between ax ante or ex post prices, the method of weighting daily rates in
the monthly TP calculation needs to be chosen. The methods can be used with both ex
ante and ex post prices, however here it is assumed that the latter technique is
employed, as it is more suitable for multiple pools. There are a number of methods of
approximating the TP for a pool of transactions that have the same rate type:
• The simplest methodology uses average market rates during each month. E.g.
loans paying LIBOR 3M are priced with average LIBOR3M on that month.
Also, daily prices can be used with daily pool balances. This is always suitable
for LIBOR 1M and shorter rates.
• However, for rates longer than 1M it is more accurate to extend the period of
time used in calculating the mean price to the term of market rate itself in order
to better reflect the transactions that build up pools. For example, in the LIBOR
3M pool on any given day, some transactions have rates that repriced almost 3
months ago, some have repriced a month or two ago, and some had their rates
reset just yesterday. So, a moving average of past three months (including the
month for which we calculate the average) reflects the actual transaction rates

48
 much better than one month average. For each rate term, a time span equaling
the term is suitable, e.g. 5 past months and the current one for a LIBOR 6M.
• For TP to be the most correct approximation of customer rates structure in a
pool, the day-by-day repricing composition of that pool needs to be taken into
account. First, it is assumed that the transactions are evenly spread in time, i.e.
that an equal piece of the transaction pool reprices each day. Then, for each
piece of pool, a reset profile needs to be built. E.g. a LIBOR 3M loan that had
the interest rate reset on the 1st day of the current month will bear that rate for the
entire month. However, another loan can be reset in the middle of the month. It
would have the LIBOR 3M from the 15th for half of the month, and a historical
rate from 3 months before for the other half of that period. Doing that estimate
for each day of the month results in obtaining a profile of weights for the
average TP to be calculated.
The weighting profiles for all three moving average methods can be shown on a graph:
4,0%

mth.1

3,0%

2,0%
weight

mth.2

1,0%
mth.3

0,0%
days
10

20

30
0

0
-9

-8

-7

-6

-5

-4

-3

-2

-1

Graph 5: Methods for calculating average monthly TP.

The third method is preferred, as it gives the best estimate of interest repricing structure
of a pool, with little extra effort necessary compared to other two methods.

49
4.4 Adjusting prices for liabilities
After building the product pools, assigning rate curves and calculating average rates, we
have the basis for TP determination. For most loans, this is enough, and the price can
equal the mean rate computed. For deposits however, additional amendments need to be
done.

4.4.1 Deposit curve

As it was mentioned in the chapter on financial markets, LIBOR rates are the rates that
banks ask for lending money to other market participants. Therefore, LIBOR rates are
suitable TPs for loans. For deposits however, we need to know the market rate that
banks pay to their depositors – the bid rate. As it is shown in the graph representing
assigning prices to pools, two curves are necessary in the multiple pool method - the ask
curve for assets and the bid curve for deposits.
Some financial instruments are quoted on a bid/ask basis, and some interbank deposit
markets also follow that rule – e.g. in Poland there’s WIBOR (Warsaw Interbank Offer
Rate) but there’s also WIBID – the bid rate. So in Poland, both curves can be directly
based on market quotes. LIBORs however are only quoted as ask curve, and the bid
curve needs to derived from it. As it was mentioned before, currently the spread to
LIBID is most often estimated to be about 0,125 p.p. (percentage point). Thus, prices
for deposits are calculated by subtracting 0,125 p.p. from LIBOR rates.

4.4.2 Reserve ratio adjustment

As it was written in the chapter on central bank (CB), in most countries banks are
required to keep a part of their deposits in reserve instead of using them to fund loans.
This reserve requirement is rewarded with interest by some central banks. Since the
funds in reserve cannot be used, the ratio of reserve is deducted from transfer price. The
only gain on those funds is the rate paid by central bank.
The overall deposit transfer price can be calculated using one of the following formulas:

TPdepo1 = ( LIBORt − 0,125) * (1 − 3,5%) + 3,5% * CBrate

TPdepo2 = LIBORt − 0,125 − 3,5% * LIBID1M + 3,5% * CBrate
Table 6: Formulas for TPs on deposits

50
The second formula uses an estimate of the interest lost due to reserve requirement,
most often a 1M rate is used. The second formula is preferable, as it is also suitable for
currency deposits, whereas the first one would result in overestimation of TP if rates for
that currency are higher than domestic rates.

4.5 TPs for other assets and liabilities

The previous subchapter explained the treatment of deposits under FTP. These products
are sold in business branches. However, there are more bank products than just loans
and deposits. Specific products are dealt in by the central unit of bank, namely the
treasury department. The specific instruments in treasury include:62
• Treasuries and other securities in held to maturity or for long term - these
instruments should have a long term transfer price assigned, e.g. 12M. The TP is
multiplied by the original price paid for the instrument at the moment of
transaction origination.
• Trade instruments (treasuries and interbank loans & deposits) are held for short
time and for speculative purposes, therefore they are priced with short term
rates, e.g. O/N. Thus, the same instruments can be priced differently depending
on their purpose and designated time of holding in portfolio.
• Derivative instruments have to be priced differently. As they are valued on
market and often don’t pay interest, they are not valued by transfer prices.
Instead, a cost of carry is calculated, relating short term rates to all the cash
flows of the instrument.
• Equity is priced with cost of equity (COE). As a source of funding alternative to
liabilities, cost of equity should be included in transfer pricing system. It can be
done by pricing fixed assets with it. Another way is to price fixed assets with
long term interest rates and include COE in all asset transfer prices. Adding the
cost of equity margin requires allocating the risk weighted cost of capital to all
the products and transactions. Introducing this margin to transfer prices relies on
the concept that internal financing requires not only debt type financing priced
with market rates, but in some part it also needs to employ bank’s capital, whose
cost differs from market prices.63

62
Early B. 2005…, op.cit., pp.185-196.
63
Smullen J. 2001…, op.cit., pp.71-96.

51
4.6 Spread components in FTP portfolio
Apart from branches and treasury, the graph above shows also the FTP portfolio.
Contrary to single pool method, where fund transfer pricing system didn’t leave any
parts of accounting interest income unassigned to products, multiple pools leave out a
significant part of interest, forming the FTP portfolio. In double pool, this portfolio
included only the spread between prices for assets and liabilities. Under the multiple
pool method, the spread includes not only the bid/ask spread, but comprises also the
differences in pool term and currency structure along with other components.
The FTP portfolio is built up by the managerial transfer of funds from businesses,
making it the source of funding for all transactions. Each negative TP paid by business
for funding a loan is an income to FTP portfolio. When the sales unit gathers deposits,
the internal transfer income is paid by the FTP unit. The total flow of funding of all
transactions is the FTP income. To analyze this bundle of flows, it is necessary to
extract the income due to different components of FTP system. Different transactions
have more or less such components.64
The graph below shows the FTP portfolio components basing on two transactions – a
domestic loan (EUR is assumed to be the local currency) and a currency deposit (in
USD):

5%
EURIBOR curve:
Domestic Loan FTP portfolio result
- ask
TP=Euribor 6M = AE segment
- mean (-0,0625%)
- bid (-0,0125%)
4% A

B
3%
C LIBOR USD curve:
- ask
D
- mean (-0,0625%)
E
- bid (-0,0125%)
2% Currency Deposit
TP=Libor USD 3M -
0,125 - 3,5%*(Libid1M-
Cbrate)

1%
/N

2Y
M
1M

3M

6M
1W

12
O

S
IR

Graph 6: Components of FTP portfolio.

64
Payant R. 2001, ‘Making A/L management performance count’, Journal of Bank Cost & Management
Accounting.

52
The difference between the price on domestic loan (point A) and the price on foreign
deposit (point E) is the result of FTP portfolio. The AE segment can be divided into:
• AB segment – currency spread – is the difference between the foreign currency
curve and the local curve. FTP portfolio receives transfer interest on a loan in
domestic currency, which in this case has higher rates than a deposit in foreign
currency. If the loan was in a currency with lower rates, e.g. in CHF, the
currency spread would be negative.
• BC segment – bid/ask spread – the difference between a loan and deposit curve
in one currency, which equals 0,125pp. for LIBOR and EURIBOR. This spread
can be cut in half by a MEAN rate into the spread earned on a loan and on a
deposit.
• CD segment – term spread – the difference between the term of loan and the
term of deposit, calculated in one currency. In this case it is positive, as the loan
term is longer than the maturity of deposit, however it can be the reverse. To
calculate the term spread separately, terms of both transactions can be compared
to a short, e.g. O/N rate. The 6M-O/N term spread is the received on a loan, and
the 3M-O/N spread is paid for the deposit.
• DE segment – reserve ratio spread – is the result of price on deposit moving
away from the curve due to the reserve requirement amendment to the TP
formula. Most often the ratio lowers TP on deposit, adding to the result of FTP
portfolio.
• An amendment not visible in the graph would appear if the amount in deposit
would differ from the loan balance. This difference doesn’t appear in rates, but
in interest transferred, since the prices are then multiplied by different amounts.
This is the assets&liabilities (A&L) imbalance spread, which develops when a
bank has more liabilities than assets included in FTP system or vice versa.
• Other amendments, which are not shown in the graph, are corrective margins
added to transfer prices. These margins are described in the following chapter.

4.7 Corrective margins

Corrective margins are another component of FTP portfolio. They are introduced to
reflect external and internal business conditions. Positive margins added to TP for

53
product pools increase both the transfer cost of loans and the transfer income on
deposits. Management can set the following margins:
• Liquidity margin – should be added to prices when actual cost of financing that
the bank faces in the market differs from official interbank rates. It can be the
result or bank’s credit risk as perceived by the market, when its financial
condition requires a premium over market rate. Also, in times of market
liquidity crisis, actual short term financing might be unavailable, and more
costly long term financing must be raised from sources other than interbank
loans. Corrective margins are added to TP to reflect the increased cost of funds.
An exemplary table of liquidity margins is presented below:
currency EUR EUR USD USD other other
term assets liabilit. assets liabilit. assets liabilit.
O/N 0,00% 0,00% 0,00% 0,00% 0,00% 0,00%
1W 0,00% 0,00% 0,00% 0,00% 0,00% 0,00%
1M 0,25% 0,25% 0,00% 0,00% 0,00% 0,00%
3M 0,25% 0,25% 0,00% 0,00% 0,00% 0,00%
6M 0,25% 0,25% 0,00% 0,00% 0,00% 0,00%
12M 0,50% 0,50% 0,10% 0,00% 0,10% 0,00%
2Y 0,50% 0,50% 0,10% 0,00% 0,10% 0,00%
5Y 0,75% 0,75% 0,10% 0,00% 0,10% 0,00%
10Y 0,75% 0,75% 0,10% 0,00% 0,10% 0,00%
20Y 1,00% 1,00% 0,10% 0,00% 0,10% 0,00%
30Y 1,00% 1,00% 0,10% 0,00% 0,10% 0,00%
Table 7: Exemplary liquidity margin table.

Margins are appointed basing on currency and maturity of product pool, with
balance sheet side (asset or liability) optionally taken into account. Using the
table, management can foster gathering of deposits and/or limit sale of loans,
when liquidity issues arise. Liquidity margins are typically positive, to reflect
increased cost of funding. Negative liquidity margins are very uncommon. When
management decides to change the table, new margins are reassigned to pools.65
• ALCO margin – reflects the target A&L structure that management has in mind.
In order to boost sales of some products and reduce the significance of other
products, margins can be used to influence product profitability. ALCO margins
are set for each product separately, notwithstanding its term or currency
structure, but taking into account the balance of transactions. Most often ALCO

65
Early B. 2005…, op.cit., pp.161-179.

54
 uses its margins to improve internal profitability of significant large transactions.
An exemplary ALCO margin table is shown below:
products <100ths <500ths <1 mln <5mln <10mln above
loan 1 0,10% 0,10% 0,10% 0,10% 0,10% 0,10%
loan 2 0,00% 0,00% 0,00% -0,10% -0,10% -0,10%
deposit 1 0,00% 0,05% 0,10% 0,15% 0,20% 0,20%
transaction 1 - - - - 0,25% -
Table 8: Exemplary ALCO margin table.

A positive margin limits profitability of a loan, whereas a negative one increases

it (the opposite is true for deposits). Unique transactions require setting one
margin only.

4.8 Pros and cons of multiple pools

The multiple pool methodology is complex and detailed in many areas. However, from
an information technology point of view, it doesn’t require much computing power or
detailed transaction information. It is not as easy to implement as single pool, however
it can work based on databases supported with internally developed software. For larger
institutions, some sort of professional application might need to be bought.
Multipool ensures a fairly good calculation of profitability for pools of float rate
products, and approximates fixed rate pools’ results basing on current market rates. It
takes into account the time structure of assets and liabilities and allows for many
adjustments. It can be recommended for any commercial bank, with many branches and
businesses, various sources of funding and complex product portfolio. It is suitable for
banks that actively use interbank transactions. The method allows for more objective
performance evaluation and provides management with tools for governing product
structure and profitability.
However, multiple pool methodology has a number of disadvantages as well:66
• Profitability of products is influenced by changes in market interest rates.
• Historical interest rates prevailing at the time of the contract are not regarded.
• Method is not suitable for long term fixed rate transactions.
• Interest rate risk is not separated from credit risk.
• Managerial results are approximated with varying accurateness.

66
Shih A. & Crandon D. & Wofford S. 2000, ‘Transfer pricing: Pitfalls in using multiple benchmark
yield curves’, Journal of Bank Cost & Management Accounting.

55
 • Increased disparity between managerial and accounting interest in the FTP
portfolio.
• More IT resources required in comparison with single pool method.
The drawbacks listed above are not crucial however, and the multiple pool methodology
is successfully used in many large banks. The main reason for preferring it to more
accurate methodologies is the quality of transaction data a bank has. If bank’s data bases
don’t allow to determine parameters like repricing and original maturity on every single
transaction, multiple methodology is the only choice. Moreover, multipool method is
the historical choice – it was employed when available hardware and software didn’t
allow for successful implementation of more complex methods. Today, it still prevails
in many banks, as switching to more advanced methodologies would require alterations
in the majority of existing software, which may be costly, time consuming, and
temporarily slow down data processing.

4.9 Historical multiple pool variation

To overcome some drawbacks of multiple pool methodology, adjustments can be
implemented. Using average rates significantly distorts profitability of long term fixed
rate transactions. Instead of current rates, historical rates from the initiation of
transaction can be used. Using historical rates allows fair evaluation of product pricing
decisions made at the time of transaction.
To resolve this issue, a adaptation of the multiple pool method divides the LT fixed rate
pool into a series of historical pools. Each historical pool includes transactions that
originated in a historical period of time, and assigns to them rates prevailing at that
time. E.g. for a pool of fixed rate mortgages, twenty historical subpools can be created
for each year in the past, with an average rate calculated based on the rates previaling in
that year. This way, transactions are divided according to the time of their initiation
with rates assigned accordingly.

56
5 Matched rate method
Matched rate method (MRM) differs from multpile pool by one crucial aspect – instead
of using transaction pools, prices are assigned to each transaction separately. This
allows for TP to mimic perfectly the customer interest rate on transactions. Matched rate
method can be interpreted as the result of employing the historical pool method with a
vast number of historical pools, one for each transaction. In many aspects those two
methods are similar – they use the same TP formulas and corrective margins, both
methods entail a FTP portfolio.

5.1 Benefits of MRM

The main differences between multipool and matched rate include:
• Separation of credit risk and interest rate risk,
• Sales unit held responsible for credit risk only,
• Business transactions based on a fixed interest margin.
• Unbiased business decisions evaluation and motivation
• Interest risk centralized and transferred to a responsible unit
MRM offers significant advantages, however it is costly to implement. It requires
buying expert applications that can fulfill a number of functions – processing of detailed
transaction data, incorporating various aspects of advanced FTP methodology and
translating interest risk data to treasury IT systems.
It can be recommended for largest commercial banks, which have detailed transaction
databases and sufficient funds to build costly IT systems. It is suitable for banks that
wish to improve business performance evaluation and interest risk management. If not
in full scale, MRM can be implemented for large fixed rate transactions first, where it
brings the most significant improvements.
Nowadays, its popularity rises due to the functions it has in aiding the assets and
liabilities management. As the only method capable of effective interest rate risk
transfer and management, MRM becomes a must in the environment of low and
variable market rates. This method is indispensable for institutions that are active on
financial markets, as they are faced with increased risks stemming from various
financial instruments in their holding.
To sum up, MRM is the choice of future, and large banks that still use multipool are
currently implementing MRM, or at least are planning to do so.

57
5.2 Business unit results
The main effect of MRM on branches and business units is that margins on all their
loans and deposits are constant throughout the transaction duration. At the time of
transaction origination, the TP is assigned based on repricing characterstic, in order to
“freeze” the interest margin. As a result, business unit knows what the profits on a
transaction will be throughout its entire life at the moment of product sale. This entails
significant changes in business results evaluation, compared to multipool
methodology:67
• With a fixed margin on transactions, business units’ profits are due only to the
factors that the unit can influence. In MRM, branch managers are rewarded for
the quality of decisions made in a given market environment, not for the effect
of changes in market conditions, as is the case in multipool method. In
multipool, business results include undeserved losses and gains due to interest
rate fluctuation.
• With interest rate risk removed from business, financial plans can be set and
evaluated despite of changing market conditions. Forecasted business results are
still valid, even if actual interest rates differ significantly from predictions.
• In matched rate methodology, branch management is rewarded fairly, which is
important for motivating future business performance. Knowing they’ll be
rewarded for the results they can influence, managers make unbiased pricing
decisions knowing total future results on a transaction. Their decisions are based
only on actual cost of funds at the moment of transaction.
• Under multipool past transactions are affected by subsequent market rate
fluctuations. Using current TPs distorts business decisions, as management tries
to avoid fixed rate transactions. They make decisions basing not only on
customer profit contribution. Each line managers tries to predict future rates and
manage interest risk, which he is not responsible for.
• Knowing the net interest margins on transactions at their origination allows for
detailed profit contribution analysis. Using MRM, this contribution can be
measured of business line level, branch level and customer level without market
rate variability bias.

67
Polakowski M. 2006, Transfer Prices – practical approach, Deloitte Poland.

58
 • Under MRM, business managers are only responsible for credit risk on their
transactions, and the interest risk is transferred to the FTP portfolio.

5.2.1 Credit risk

With interest risk removed, business results are influenced by credit risk only.
Sometimes, credit risk can also be removed from the branch. This is justified in case
when bank’s structure includes a centralized credit risk unit, which takes over the credit
decision authority from branches.
In such cases, when the credit decision is centralized, then the credit risk should be
removed from business transactions. This can be done by attributing an average credit
spread, expressed in percent of balance, to the sales unit as cost of credit risk. Actual
credit losses should be then attributed to credit risk unit, with average credit spread as
income. The average spread can be calculated for different products or customer types
separately, based on past and predicted credit quality of product portfolio.68

5.3 Transfer price calculation

The core characteristic of the MRM is the assignement of individual transfer prices. For
this purpose, just like with multipool, market rates are used. Contraty to multiple pool,
there is no ex post or ex ante price dilemma – all TPs are based on rates prevailing at the
moment of transaction origination. In practice, daily interest rate fixing is used,
although for large transactions, intraday rates from the exact moment of transaction can
be used. Rates from a curve are assigned to loans and deposits basing on their repricing
characteristic. This doesn’t necessary mean a fixed TP, which is true only for fixed rate
transactions. For float rate deals, TP mimics changes of customer interest rates on each
loan and deposit. Other components of TP formula, like corrective margins, are kept
constant from the moment of transaction origination. Only then the total interest margin
on the loan will be unchanged for the transaction life. Just like in multipool, prices on
deposits are taken from the BID curve and adjusted by reserve ratio. The specific TP
calculation method depends on the interest rate type on a transaction.

68
Deventer D. 2002…, op.cit., p.16.

59
5.3.1 Float rate transactions
Transactions with interest based on regularly repriced market rates obtain a TP based on
the market rate that the customer coupon is referenced to. For example, a 1 year loan
paying interest based on a 3M LIBOR will have a TP based on the same rate. Each
quarter, on the day that customer’s rate is reset to the current 3M LIBOR, the TP is reset
as well. As a result, the interest margin on the loan is constant, despite of changes in
both TP and customer coupon.
Float rate instruments reprice on a given day with a frequency dependant on their
reference rate. When a transaction reprices during a month, it is important to observe
transaction balance before and after the reprice date. The balance can change on any day
due to early withdrawal of deposit or due to prepayment of loan, therefore it is
necessary to differentiate between the balance before and after repricing. As a practical
consequence, with MRM, transaction balances need to be measured daily.69

5.3.2 Internal rates

Similarly to multipool, products with yields set internally by bank management get TPs
based on market rates with term best approximating the actual and predicted changes in
internal rates. For reasons previously explained, most often monthly rates are used,
sometimes quarterly rates (if management changes rates rarely, or when market
conditions are stable). This entails a so called basis risk – a risk that internal rate will
change with different frequency or by different amount than its market proxy. Contrary
to interest rate risk, basis risk isn’t usually removed from business level. This is due to
the fact that its business line management who is responsible for product pricing, and
it’s their authority to use internal rates or to change them to market based rates in order
to get rid of basis risk.70
Despite of the similarities between the multiple and matched rate methods, there is
however one difference– in MRM, no average rates are allowed. Every transaction must
be priced like a market transaction, with repricing schedule compatible with market
standards. In order to best replicate internal rate change timetable, all products with
internal rates have their TPs reset on the first day of each month (or quarter). This

69
Whitney C. & Alexander W. 2000, ‘Funds transfer pricing: A perspective on policies and operations’,
Journal of Bank Cost & Management Accounting.
70
Deventer D. 2002…, op.cit., p.15.

60
reflects the widely employed routine of introducing changes in bank rates from the
begging of month, in order not to complicate monthly managerial accounting
calculations. For example, a loan paying interest based on internal yield will have its
LIBOR 1M TP (if such rate is assigned) reset on the 1st day of each month, independent
of the actual transaction date. This is actually a drawback compared to the multiple pool
approach to internal rate products pricing, since changes in rates on one day have a
significant influence on the profitability on entire portfolio of products. Using average
rates in multipool method smoothens any potentially large daily rates variations.
For large individual transactions with unknown maturity, another method can be used.
If the transaction required a direct interbank transaction to fund it (or to place funds
gathered from it in case of a deposit), the rate on respective market transaction can be
applied as a fixed transfer price (after necessary amendments).

5.3.3 Transactions of indeterminate maturity

Transactions with unknown maturity are another products treated similarly under
multipool and MRM. In matched rate methodology the multiple layer approach to
product portfolio is also employed, dividing each product into layers with different
actual maturity (historical or predicted), with respective market rates assigned. The
average weighted maturity of products can also be calculated. There are however some
differences. First of all, the subpool approach is obligatory in MRM, whereas in
multipool it was one of the options. Next, in MRM, there are usually more pools than
the typical couple in multipool. Finally, there’s no average rates employed, and each
layer has a rate that reprices according to market rate schedule. For example, a current
account portfolio would typically have the following layers:
• a 10 year layer, with amounts stable during many years and with a 10Y IRS
price, changed every ten years;
• a 1 year layer, with a LIBOR 12M based price, reset each year on 1st of January;
• a monthly layer, with a 1M rate reset on the 1st day of each month;
• a daily layer, with O/N transfer price reset daily.
Similarly to MRM for internal rate transactions, instead of using average rates, yields
from a specified day are used. This doesn’t necessarily improve the quality of FTP
system, however it is a consequence of interest risk transfer to Treasury department, and
will be explained later on.

61
5.3.4 Fixed rate transactions
Compared to the previously described transaction types, the treatment of long term
fixed rate transactions is completely different under MRM than under multipool. Each
fixed rate transaction is assigned a rate from the curve basing on its original maturity.
Actually, the result is a slightly modified version of MRM - the maturity matching
method (MMM). There is no repricing schedule, and the fixed rate on transaction can be
only vaguely based on market rates. Therefore, a TP is assigned basing on the original
maturity of transaction.
For example, a 5 year fixed rate commercial loan is assigned a 5 year swap rate
prevailing in the market at the moment when the transaction was originated. This rate is
then kept constant for the entire life of the transaction. As a result, each transaction has
a fixed interest margin for its life. This is where MRM differs most significantly from
multipool, where the interest margin would fluctuate as market rates change.
For transactions with unusual length, prices are calculated based on the interpolation
methodology. E.g. a four and a half year loan would be assigned a TP calculated as a
mean of 5Y IRS and a 6Y IRS.

5.3.4.1 Amortizing loans

Assigning TP to transactions basing on their original maturity can pose problems when
dealing with amortizing loans, e.g. mortgages. Amortizing loans pay back principal
evenly throughout their lives, instead of paying it in a lump sum at the end of
transaction. As a result, their balance diminishes constantly. Therefore, funding for the
transaction isn’t raised in the whole amount for its entire life, as a fixed rate based on
contractual maturity would suggest. In order to better reflect the time span that the funds
are necessary for, actual maturity (shorter than contractual) is calculated and used to
assign the constant TP. A number of methods can be used to fulfill that goal:71
• Simple average – this method divides the loan into a series of all the principal
repayments, and assigns to each one a TP from the moment in the futures when
that principal cash flow will take place. Then, a simple average of all TP for
consecutive payments is calculated.
• Balance weighted average – this a modification of simple average method, when
all the TPs assigned to principal cash flows are weighted by the size of cash

71
Whitney C. & Alexander W. 2000…, op.cit.

62
 flow, i.e. by the portion of principal repaid. The principal repayment schedule
set at origination is used, without taking into account any potential prepayments.
This method is preferred to the previous one.
• Duration based – instead of using initial maturity, duration ca be used to
determine average length of transaction. Duration calculation was described in
the chapter on risk management. In short, duration weighs all the cash flows by
the time at which they occur.
• Median life – the simplest way to determine actual term of transaction is to use
the time at which half of the principal will be repaid according to schedule. For
evenly amortizing loans, this would equal half of the transaction life. This
method is very popular.
These methods provide quite similar results, however for long term instruments in a
variable interest rate environment, results may differ. The actual term determined by
one of the methods is used not only to determine the transfer price, but also for other
purposes, like assigning corrective margin. E.g. using the median life method, a
liquidity margin is assigned to mortgages based on half of their contractual lives.

5.3.5 Prepayment option adjustment

Most products provide the customer with an ability to of early principal payment. Loans
can be prepaid and deposits withdrawed ahead of schedule. This risk is esentially left
together with interest rate risk in the FTP portfolio. Prepayment risk is mostly
significant for long term fixed rate loans. At loan origination, funds are raised for the
expected life of transaction, at market prices for that term. Prepayment results in a need
for a reverse transaction for part of the initial amount, but at now previaling rates. FTP
center isn’t able to control that risk, therefore branches should be charged with the cost
of such transactions. However, charging a marked based penalty for prepayment or
withdrawal would result in significant costs for business lines in periods of interest rates
decline, since prepayments are massive in such economic environment. A better method
of including potential prepayments in FTP system is to calculate the value of
prepayment option owned by customers on various products. This option value is then
added to the transfer pricing rate (or substracted for deposits), similarly to other
corrective margins.72

72
Deventer D. 2002…, op.cit., p.17

63
5.4 FTP portfolio management
Fixing the interest margin on business transactions entails a transfer of interest rate and
liquidity risk to the FTP portfolio. The portfolio is managed by ALCO (Assets and
Liabilities Management Committee), however on a daily basis, the Treasury department
administers the total pool of transactions.73
The place of FTP portfolio in the overall bank structure is illustrated in the graph below:

Graph 7: Business Units in a Bank.

Treasury, under the guidance of ALCO, manages the risk of FTP portfolio. Treasury is
divided into Trade book, which trades with the market both for profit and to close Bank
book transactions and Bank book, whose task is to manage the surplus or lack of
funding. Treasury is able to borrow and lend on the market, in order to ensure the
necessary level of funding. Transferring all FTP transactions to treasury systems
provides detailed information on interest rate and liquidity risk of the entire balance
sheet. These risks are materialized in the overall FTP portfolio due to bank's funding
mismatch, caused by sources and uses of funds having unmatched repricing terms,
amounts, or origination dates. The mismatch is mainly composed of volume and term
differences, the latter being more significant. The maturity mismatch component is a
result of differences between the shorter and the longer tenor side of balance sheet. As is
often the case, financing long term fixed rate loans with shorter term deposits conveys a
risk that should interest rates rise, interest cost on deposit will increase while interest
income on a loan will remain unchanged.74
However, loans and deposits are valued in financial reports using accrual accounting –
meaning that they’re presented in their nominal value, adjusted only for credit risk.
Their book value doesn’t reflect the potential influence of market rate changes on future

73
Zagorski D. 2000, ‘Understanding Profitability Through Transfer Pricing’, Capital Market News,
September issue, Federal Reserve Bank of Chicago.
74
Payant R. 2000, ‘Funds transfer pricing and A/L modeling’, Journal of Bank Cost & Management
Accounting.

64
profits. On the other hand, most instruments in treasury department (derivatives and
trade securities) are marked to market (MTM) – their price is recalculated constantly in
order to reflect how current market rates influence their value. In marked-to-market
valuation methodology, the value of an exemplary loan would be influenced by changes
in interest rates to the extent of predicted changes in future profits. Therefore, during the
transfer of FTP transactions to Treasury, the valuation method is changed. MTM
valuation of loans and deposits allows to measure interest rate and liquidity risk on the
entire bank’s product portfolio. Translating all FTP transactions to MTM is possible
provided there’s complete information on repricing and maturity characteristic of all
transactions. This is available only in Matched Rate Methodology of FTP.
To allow for interest and liquidity risk management, all the transactions in FTP portfolio
need to be observable by the Treasury department. This can be done provided that the
treasury IT system responsible for following market transactions is able to communicate
with databases on FTP transactions. Treasury can then manage all deals and close them
with market when necessary. It doesn’t mean all transactions are paired off against one
another or on the market. The goal of A&L management isn’t to eliminate all funding
mismatches but to control them, since they are a source of bank’s profits. In order to
fulfill this goal, ALM uses a number of techniques of interest rate risk management that
accompany market-value accounting, e.g.: duration analysis or cash-flow analysis. For
liquidity management, analysis of cash flows is combined with gap analysis, scenario
analysis can also be used.75

5.5 Variations of matched rate methodology

The MRM is the only method that allows proper transfer of interest rate risk from
business, leaving there a fixed interest margin. However, for foreign transactions,
currency risk remains in the branch. Some variations of MRM try to overcome this
problem, by setting a fixed exchange rate to transactions based on their origination date.
This doesn’t account for the fact that each CF from or to customer in foreign
transactions is priced by a different exchange rate. Therefore, a repricing exchange rate,
similar to repricing interest rate should be assigned to such a transaction. However, the
exchange rate issue is rarely covered by FTP systems, since it isn’t necessary for risk

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Alexandre A. 2007…, op.cit., pp.100-200.

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management. Banks typically keep a very low open currency position, not taking much
risk in that area (while they’re open to interest rate risk).
Another approach modifies the matched rate methodology by using its fixed rate
variation for all transactions. The matched maturity rates are assigned to all deals,
including those based on float or internal rates. This approach is derived from a concept,
that it’s the transaction term, not the rate repricing characteristic that indicates its cost of
financing. This method of including cost of liquidity is alternative to the corrective
liquidity margin, used in regular FTP methodologies.

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Conclusion
In the introduction, research questions on fund transfer pricing were asked. The
conclusion presents summarized answers to those questions, fully developed in the
thesis.

Is FTP necessary, or can a bank cope without it?

Fund transfer pricing system is necessary for successful management of any major
financial institution and literally all large banks have implemented one of FTP
methodologies. In a highly a competitive environment, with historically low interest
rates and decreasing interest margins, banks need to improve their performance
management abilities in order to achieve sustainable profits. FTP is the best tool for
analyzing net interest income, which is the biggest component of bank's profits. FTP
system is fundamental for financial institutions and no bank can be well-managed
without possessing some sort of transfer pricing system.

What are the advantages of using an FTP system?

Various FTP methodologies provide different sets of advantages. Overall, fund transfer
pricing provides the following benefits:
• Allows to calculate a cost of funds and apply them as a price to all internal
sources and uses of funds.
• Allows to plan, motivate and evaluate management performance based on fair
appraisal of results
• Permits removing interest rate risk from sales divisions by setting a fixed margin
on transactions, leaving only customer’s credit risk
• Allows transferring interest rate and liquidity risk to a central unit responsible
for its management
• Facilitates management of market risk through assets and liabilities management
• Transfer price allows to minimize interest margin fluctuations due to market rate
changes
• It prices marginal cost of funds in order to improve business decision making
• Facilitates deep analysis of interest income, by product, branch, business line,
transaction, etc.

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 • Interest income decomposition improves product pricing and tailoring the
product offer to various needs

How can it improve results?

FTP system improves profitability by enhanced pricing. Applying a transfer price most
reflective of actual funding cost to each transaction allows for perfected decision
making. Prices for products are then set at a level than ensures an increase in bank’s
total profits. Customers can be evaluated based on their overall contribution to bank’s
results, and selective conditions can be awarded. The profit contribution of branches and
business lines can be appropriately estimated, allowing to close down the units that
don’t contribute to profitability. The same methodology can be used to evaluate
management and even individual employees, basing on their contribution to profits,
compared to their financial targets. Statistical studies show that accurate fund transfer
pricing can generate a measurable increase in a bank’s interest margin.
Another benefit of FTP is the quality of interest rate and liquidity management it entails.
Transfer pricing system can effectively move those risks away from sales units into a
centralized portfolio. The overall level of bank’s risk can be then observed, divided into
sources of origin, and managed. Asset and liability management is more effective when
it can be conducted towards all bank’s loans and deposits and their funding mismatch
directly by Treasury department. This is possible only with a sophisticated FTP system
with a direct connection to Treasury IT systems.

How to build an FTP system, is there an easy way to do it?

Building a basic FTP system is relatively simple. The easiest way to implement an
initial FTP system is through the use of a single pool method. In this method, only one
transfer price is established, calculated based on average interest rates on all products. It
is enough to divide interest profits between assets and deposits and to calculate branch
results. This system is cheap and easy to apply, with literally no investment in IT or
know-how necessary. It can be gradually enhanced, e.g. by using two transfer rates, one
for deposits and another for loans, allowing to control generation of deposits and loans
independently. Further amendments can include accounting for reserve requirement,
building more pools for different products, or using current market rates instead of
internal cost of funds. Such a system would be easy to establish while making transfer
pricing effective.

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In its more developed version – the multiple pool methodology, further refinements are
possible. Various types of moving average are used to calculate prices for products with
different repricing and maturity characteristics, more accurately reflecting the actual
interest rates on transactions. Corrective margins are introduced, e.g. in order to apply
cost of liquidity to transactions. The growing differences between transfer cost and
income form the transfer portfolio. In multiple pool methodology, a reasonably accurate
calculation of profitability on different products is possible. Time structure of assets and
liabilities is accounted for, and marginal market costs are used as benchmark. This
method is well suited for most users, especially when applied to products with unknown
maturities or based on internal interest rates.

How to develop a perfect FTP system?

The choice of FTP methodology depends largely on resources available: manpower,
know-how, quality of data bases, IT systems capacity and the budget for FTP. Financial
institutions seeking to develop the perfect FTP methodology, should implement the
matched rate method. It is a complex method, requiring significant investments and
developments.
However, only this method allows for proper transfer of interest risk to a central unit,
leaving a fixed interest margin in the business. Using historical rates individually
assigned to transactions ensures a proper calculation of profits on customer and
transaction level. A fixed margin ensures fair evaluation of management decisions and
business results. Business decisions and their assessment are unbiased by market rate
fluctuations, which are uncontrollable by sales unit. Removing interest rate risk from
business units allows for proper risk management in a central unit. Treasury can observe
risk characteristics of each transaction by valuing them by marking to market.
The matched rate method should be implemented by any large bank that has a
significant amount of fixed rate transactions on balance sheet. It is also suitable for
institutions that wish to better control their interest rate and liquidity risk.

Banks need to employ one of FTP methods in order to be able to analyze contributions
to overall interest profit, to control and evaluate business results. Lack of a proper FTP
system negatively influences bank’s overall profits and deteriorates the quality of risk
control. FTP system is crucial for financial institutions and no bank can successfully
expand without implementing one of its versions.

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