Internal Funds Transfer Pricing
Transfer Pricing Methodologies to be used for Fund Based Products
The methodologies discussed below are only applicable for Matched Maturity FTP. In Net Funding and Pool Funding,funds are treated as the same and no discrimination is made from one product to another.
Demand Deposits Banks have used numerous methodologies for transfer pricing Demand Deposits. The main issue with transfer pricing these products is determining their maturity.
- There are several ways to deal with demand deposits. The simplest is to put all the deposits into one maturity bucket, which can be the horizon of the bank and beyond. Then the bank can Use a single rate for the entire amount. This is a Blended Rate which is a combination of a long-term moving average transfer rate and a short-term moving average transfer rate. However, this is quite unrealistic and unacceptable.
- Another solution is to rely on conventions with respect to their amortization. An amortization rate of 5 – 10% every year can be assumed.
- A better approach is to divide the deposits into core and volatile. The core portion can be viewed as a more permanent source and the volatile fraction treated as a shortterm debt. Various techniques can be used for determining the core portion :
A term deposit (or Fixed Deposit) may be for a short duration of 15 days or may be for a longer term of up to 5 years. Such products are not very complex to transfer price, as the maturity is known well in advance.
- Depending on the maturity of the deposit, the transfer pricing rate will be taken from the Bid Curve.
- In case the deposit is reinvested with interest on maturity, it should be treated as if a new FD has been opened on that date and the old one has been retired. The transfer price will be based on the Bid rate on the date of renewal.
- Prepayment will attract a penalty.
Commonly used methods of FTPThe Cost of Funds Method In the Cost of Funds method, the existing COF is used for FTP. This method sounds intuitively appealing as the assets are funded from the resources raised and therefore the cost has to be relevant. However, this method raised several issues:
- There are many assets and liabilities whose characteristics differ. Each type of resource has a different cost.
- The volumes of transactions for a particular maturity may differ. Therefore, the match cannot be exact i.e. the liquidity risk is not considered.
- For BU’s also there is a similar problem. Generally, the balance sheet of the BU does not match. The deficits have to be matched by resources of other units. It does not sound right to assess the COF of another BU to the BU that generates the deficit.
- Resources that have a low financial cost may actually be subsidizing the lending business e.g. if loans are lent out from funds generated by demand liabilities the margin of the lending BU will be quite high due to low
- COF. Therefore the BU generating the liability is not compensated fairly. Further, it would be unrealistic to assume that all lending operations will be funded from demand liabilities. Given these inconsistencies, the matching of existing sources with assets is unrealistic. Funds Transfer Pricing needs better rules.