Funds Transfer Pricing in Commercial Banks: A simple Model: Chapter 5
5 A SIMPLE FUNDS TRANSFER PRICING MODELIntense competition in the financial services industry has reduced the potential of traditional operations to finance loans through deposits. The current situation forces to reconsider traditional approaches to improve the efficiency of banks: increased attention to the internal generation of bank capital, financial innovation, the search for new investment opportunities, reduce management costs, etc.One of the most significant innovations in banking - the creation of risk management measures was able to introduce risk transformation that are comprised of diversified risks as a result of the increasing number of borrowers. Risk sharing for instance allows the creation of assets that encompasses a variation of risk characteristics that are appropriate for the different kind of customers. Several models have been created to mitigate the emerging risks, but only few approaches are proven to be simple yet effective. A simple fund transfer pricing model can be drawn from different FTP approaches such as Multiple Pool Approach. It is much simpler than match maturity and the problems associated with single rate can be overcome by matching the different characteristics of liabilities and assets using an alternative type of funding scheme. The principles of multiple pool approach include using both short-term rate or Libor and long-term rate or swap. They can be applied to assets and liabilities by approximating maturity. A spread can also be included to the swap and labor to be able to accurately determine the real cost of borrowing in the bank. However, the approach is still considered to be blunt and has the possibility to fail in assessing the real cost of liquidity. Therefore, a simple Funds Transfer Pricing Model is being proposed to draw advantages such as rate flexibility and adequacy in indicating market reality (Kawano, 2005).5.1 A summary of findings
A simple fund transfer model drawn from the multiple pool method was found to have its advantages such as, it’s more indicative when it comes to market reality and the rate is more flexible. Financial providers and customers consider this method because of its volatility in portfolio funding. In addition, the basis of its utilization can either be the net or the gross wherein each branch or department can be credited or charged as either the user of the provider of funds. However, the method also has its drawbacks such as utilization requirement, which is far more than what the single pool requires. It also has a potential for reconciliation differences (Kawano, 2005) and implementation is more complex than the single pool method. Despite the approach's drawbacks, the best characteristic of the method is its simplicity, which can be an advantage in terms of accurately drawing the fundamentals of the proposed simple fund transfer model. In addition, the proposed model also uses average rate instead of the marginal rate because it will allow the simple FTP model to integrate internal cost of funds approach more easily.
5.2 A simple FTP model
During the initial overview of different Funds Transfer Pricing approaches key concepts were studied to understand the framework of FTP in commercial bank. These concepts were after summarized to lead to an idea for simple FTP model. Figure 7 depicts a simple Funds Transfer Pricing model. This model is designed on the basic principles of matched maturity approach to meet the immediate requirements of commercial bank, but it simplified by mixing some principles of multiple pools and matched maturity approach to overcome some of the main drawback of matched maturity approach and at the same time provide a framework for future commercial banks business needs.The following building blocks (principals) where identified and served as a guide for FTP model presented in this thesis that can be empirically validated to improve FTP framework of commercial bank or can be used as an additional benchmark of an existing FTP to redesign it.
5.2.1 Process
Leaving without changing the classic model of the FTP framework, where we have 3 business units, in the model presented here the functions of Treasury involves-managing all financial risks. Concentrating risk management in one department (make specialization) and complicating them (the use of derivatives - futures, forwards, options and swaps - for hedging risk reduction through securitization), I increased the efficiency within the banking capital generation, and expanded investment opportunities to reduce financial risks. And what is very important for small banks all this is less costly and can easily fit into the classical model of the FTP. Leaving unchanged the basic principle characteristic of multiple pools (TP differentiation in financing various types of assets from liabilities of varying urgency) and I kept the unity of Transfer Prices between units, but with the advent of another center revenue is unity evenly divided not between two departments, but between the three - liabilities, treasury and credit.Treasury manages risk. This setting of warehousing is involved with hedging. Otherwise this was not need to be paid but it was not free form managing the common risk
. Therefore the ABC model presents and adjustments to calculation of TP based on internal cost of funds, where in classical multiple pool FTP approach is an average interest rate on bank's products. In ABC model the TP are equally allocated between three business units. Therefore, the resulting rate between average rate received on loan and paid on deposits is divided equally between each unit.The data needs on unit in treasury Assets and liability needs each every data on each division of unit, the cost are being premeditated with funds charges it will be delegate to each detachment. Its accountability and remaining costs for running the interest risk will reflect in the allied cost of different business. Rate between average rate received on loan and paid on deposits is divided equally between each unit.
5.2.2 Establishing Funding Curve
A conventional curve is estimated by outlining the conjunction between output to maturity and time to maturity, and then modified to convey the extending needs of various locations. The rates are deputized to the respective transactions that obtain the bank. For instance, a five-year bond would have a distinctive rate than a 10-year bond. In conclusion, all of the rates are commence into the Fund transfer pricing system. The primitive conventions of the baseline uncertain yield curve is that the data input points exemplify the liquid prices. This is hypothetical for banks that carry on a benchmark bond issuance category. When undertaking to put together to ensure a risky curve, the practitioner is counteracted by the lack of corresponding liquid prices, similarly by the discrepancy of distinction classes and type of products that are used as collateral when boosting a secured funding. The issues to construct a secured funding curve are Collateral assets class, Daqta point transparency and Liquidity of collateral.
5.2.3 Transfer Prices
In the ABC Model Transfer Prices for the pool are calculated internally – as an average interest rate on bank's products. According to Randall T. Kawano this way is much simpler than marginal rate method and minimizes fluctuations from market rate change and reflects historical rates/prices (Kawano, 2005; Grant, 2011). The only difference is introduced in the model that instead of dividing the difference between average rate on loans and deposit by two, the difference are divided by three instead. The formula presented below;TP = (AR (loans) – AR (deposits))/3By calculating TP in this way the model assigns equal TP to each business unit in the model. In calculation of pool process should be done according to the best approximation of the average goal in needed for the customer’s interest for higher rate.
5.2.4 Building Pools
- Pool 1: Long term fixed rate products
For the product in process of long term (LT) system fixed rate. For example products with fixed rate mortgages are difficult to handle there will be a complication under the multiple pool method as if their rate is structure through inhomogeneous replica. Otherwise, in the long term system this is easier to replicate.It can have a transaction compilation that has been laded out within a specific given time.
- Pool 2: Float and internal rate products
The products are fixed rate with short term (ST) and with the products with long term maturities, however, float are depend and can be treated uniformly. Mainly of the banks have rates set by their management in particularly in products. Such as internal rate and needed to have a substitute in market having assigned rate, this rate is already implied by prudence of management, conclusion to stay the usually rate made by a monthly cycle for the products with maturities and internal rate are often a higher rate in particular of 1M rate to be assigned.These methods are conceptually ideal in buying and selling funds, this is just simply charge based on one rate of the providers and users of the credits. This will be simply and user friendly as to understand. However, there will be no providing incentives and distinctive loans and only applicable for small banks that has a stable source of funds.
Pool 3: Blended term for indeterminate maturity products
As for the internal rate are combined in current accounts or credit card. A shorted rate will imply to the combined system in due of unknown maturity of interpreting two or more layers of rates that differs in average rate. The overall pool layers will determined from the all combined rates. But in some cases there is always some funds will be residue from the whole pool. In other way around it will varies in certain minimum level of funds in each bank of product.
{Dear writer, in this section I would like to, first rename Pools, because I exactly took the names from Kugeil. L (2009) work, second describe each pool and say about if pool could be divided in more sub pools to get better distinction of products in pool under consideration, third to summarise each pool into table. Please keep in mind that that now we are using an internal cost of funds!!!}
5.2.5 Risk Control
It is the excessive depletion or impact and the enormous feasibility of arising are first handheld, risks with lower probability of obtaining and lower loss is handled in deriving order. In practicing the process of apprising overall risk can be crucial, balancing resources used to modify between risks with a high credibility of occurrence, but lower loss contrast and a risk with a high loss, but lower probability of occurrence can generally be blunder.
In addition, it implicates assuring that the main risks implicit in each activity are conceded and handled by means of a systematic process of exclusion, degradation, alteration and constrain. Risk management is based on logical process by Hazard identification, clarification and dimension of risk outline and risk management and control by achieving counter measures.
5.2.6 Performance Management
FTP (Fund Transfer Pricing) is an accounting management contrivance that specialized in banking industry to be the used of improvability on its profit. Through this program a bank can analyze the source of profit, funds, that provide the means of a management. The best practice of this is an contribution of the market based value in each assessment of individual in their occurred financial state of instrument and its origin.
5.2.7 Reporting, Communication and Transparency
As the (banking) background innovations over time, the FTP outline and the performance it invigorate must be recapitulate frequently. Furthermore FTP should be entrenched into the association and administrative practices, as well as the innovation contrivance endorsement progression and sales preparation. To certify the approval of the FTP outline within the bank, transaction and system of method must be adequately acknowledged, coverage should be self-analytically and all stakeholders should be trained punctually. Only transparency will guarantee that the FTP outline can be implicit and will be conventional by the distinctive revenue capital.
5.3 Example of ABC Model
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5.4 Conclusion
In this conclusion, this research assault presents conclusive urbanized answers to summarized Fund Transfer Pricing (FTP) In this greatly milieu increase and decrease the marginal sustainable profits to analyze the ability of the management on its net profit, which one the major module of the fundamental system pricing for finance that can be well-operated without going through the process of transfer system.
FTP will be the traditional key pricing balance that centralizes the risk of the performance and management liability on the liquidity of the uncertain measurement to be adjusted the associated financial exposure. This research approach more graduated process on the integrated transfer prices on management risk evaluation.
Reference:
- Bowers, T. E. (2006). Transfer Pricing Indeterminate-Maturity Deposits. Journal of Performance Management, 19(1), 26-44.
- References
- Kawano, R. T. (2005). Funds Transfer Pricing. Journal of Performance Management, 18(2).
