A perspective on policies and operations

Funds transfer pricing: A perspective on policies and operations


Funds Transfer Pricing measures the “true” cost of funding an earning asset and credit for an interest-bearing liability. Through this management accounting technique, a bank can gain a better picture of the net interest margin component of overall profitability.

The scope of funding also extends to all other balance sheet amounts to include non-interest bearing funds and capital. Thus, the impact of allocated capital and the carrying cost of fixed assets and receivables can be measured.

Funds Transfer Pricing (FTP) is conceptually simple. The actual implementation of a good FTP system and process can, however, be a complex undertaking that involves both policies and operations. This article describes the different views of the issues, as well as the typical FTP practices seen while implementing FTP methodologies and systems at banks around the world.


FTP is a management accounting technique used to calculate the true net interest income component of profitability for business units, products, and customers. FTP helps build the income statement for each of these views by calculating the cost of funding assets and the credit for funds provided (mainly deposits).

Three important reasons why banks do FTP are:

* Improves profitability through improved pricing,

* Enhances asset/liability management, and

– Provides an important component of an integrated profitability reporting solution.

The real benefit of using FTP is to help to boost the bottom line. One study has shown that pricing based on accurate FrP can generate a five basis point increase in net interest margin. This could mean $5 million of additional income per $10 billion of assets as shown below.’

However, establishing the policies and actually executing FTP can be very complex.

The balance of this article addresses both the determination of the FTP rate for a particular instrument or group of instruments (Section II) and the selection of the FTP balance against which the FTP rate will be applied (Section III). Additionally, operational issues surrounding integration of FTP results with asset/liability management and typical implementation approaches and tradeoffs are described (Section IV).


Determining the “best’ FTP rate involves policy decisions in three important areas:

1) Selecting the appropriate Base FrP Rate Index Curve

2) Adjusting the Base FTP Rate Index Curve to derive the Adjusted FTP Rate Index Curve

3) Selecting the point (or combination of points) along the Adjusted FTP Rate Index Curve that best reflects the instrument being transfer priced.


Banks typically select the base FTP rate index curve according to what they believe is an accessible alternative source or use of funds for the type of institution or instrument. For example, global “money center” banks may select an inter-bank rate index (e.g., London Inter-Bank Offer Rate or LIBOR) because they actively trade in this market. Regional or “super” regional banks may also select this rate index for particular instruments which are tied to inter-bank or other rate indices (e.g., United States Treasuries). Community or “super” community banks may select the single Federal Funds Rate as their accessible alternative source or use of funds, and other institutions may require a blend of inter-bank and SWAP market rates to derive the base FTP rate index curve.

The base FTP rate index curve can also be thought of as a yield curve, which is a representation of the term structure of interest rates as shown below.3

A yield curve simply plots the relationship between time to maturity and yield to maturity for a given type of financial instrument. Well-known yield curves included LIBOR and U.S. Treasury Securities. There are also numerous others. Normally, a yield curve in the currency of the instrument is used, although cross-currency yield curves are sometimes applicable for measuring the return on foreign currency investment where the funding source is in the domestic currency.


Adjustments to a base FTP rate index curve are often necessary to reflect unique attributes of the particular institution and/or instrument. Four possible types of adjustments are common: institution credit risk, bid/asked spread adjustment, liquidity adjustment, and option-pricing adjustment.

Institution Credit Risk Adjustment

One basic type of adjustment is the bank’s own credit risk … when its financial condition may require a premium over the market rate. In such a case, the base yield curve would be adjusted upward to reflect the fact that the bank cannot fund at the pure market rates.

Typically, a credit risk premium increases for periods farther into the future depending on a number of factors including the bank’s financial condition and relationship with market counter parties. Since most banks do not actively procure funds at all points on the yield curve, much of the derived yield curve is estimated based on anticipated credit risk differential.

Bid/Asked Spread Adjustment

Bid/asked spread adjustment provides a differential between internal charge for funds used and the internal credit for funds provided as illustrated on the next page.

Bid/asked spread adjustments to the base FTP rate index curve are usually made to provide explicit revenue credit to the bank’s treasury department for ‘brokering” funds providers and funds users. A 10 to 15 basis point spread is common to cover operating costs incurred by the bank’s treasury department for trading funds.

Liquidity Adjustment

Liquidity adjustments can be made to the base FTP index curve for instruments that may have the same duration or repricing period, but due to differing liquidities are not of the same value or cost to the bank. For example, a fixed rate loan with a seven year duration may receive a lower FTP charge than a similar asset with the same duration due to the ability of the bank to convert the loan into a more liquid investment, say, by using a secondary market for securitization (Fannie Mae or Freddie Mac).

Option Pricing Adjustment

Option pricing adjustments are used to reflect the “cost” of providing the customer an option or “right” to pay off a loan or redeem a deposit at no charge before the contractual maturity date (e.g., as with a mortgage with no pre-payment penalty). Assigning an early pay off/redemption option cost to an instrument can be done as part of an explicit charge when the instrument is originated (i.e., all instruments receive a small charge to cover those which will actually be paid off/redeemed early) or when the individual instrument is paid off or redeemed early.

Banks must be careful, however, when selecting an option pricing approach for individual instruments when they are paid off or redeemed early. For example, mortgage loan payoffs prior to maturity occur randomly due to several factors – the timing of interest rate shocks, customer sensitivity to rate movements, and relocations, to name a few. There is a tradeoff between this additional FTP precision and the special processing required to identify which customers have exercised their options during the reporting month.

Many banks typically apply option pricing adjustments at the product or portfolio level instead of individual instruments to strike a balance between absolute FTP precision and processing requirements. This approach is used to provide a slight charge to the product equally over its life. Normally, the cost of the implied option increases for instruments with longer maturities, such as a fixed rate mortgage with a 30 year contractual maturity.


So far, it has been shown that an FTP rate is derived from the base FTP rate index curve plus or minus adjustments for various factors. The adjusted FrP rate index curve, however, covers multiple time periods and rates. Selection of the one rate to be used in calculating the FTP charge or credit involves consideration of many alternative points along the yield curve. The exception is a “bullet’ instrument which requires only that a single point along the yield curve be selected.

Bullet instruments are less complex since total cash flow is received or paid out at the end of the instrument’s term. The point along the adjusted FTP rate index curve that corresponds to this term can be used for FTP calculations.

The more common situation involves an instrument that has periodic principal cash flows, such as a loan with monthly payments.4 Accounting for these types of instruments requires application of Marginal Matched Maturity FTP methods.

Marginal Matched Maturity

Marginal Matched Maturity is a management accounting technique used to derive a single FTP rate from a series of rates along the adjusted FTP rate index curve that corresponds to the principal cash flow of an instrument being transfer priced.

Common approaches to Marginal Matched Maturity FTP rate determination are:

– Simple Average,

– Strip Balance Weighting,

– Duration Weighting, and Median Life.

All four variations are designed to derive a single FTP rate that reflects principal cash flows over time and interest rates that vary by the time period in which the principal cash flow is received. Each variation is explained below.

Simple Average

The simple average method calculates the average of the points along the adjusted FTP rate index curve corresponding to the receipt (or disbursement) of the instrument’s principal cash flow as illustrated on the next page.

In this example, a rate of 7.593% would be applied each month to the average balance of a one-year instrument to compute the monthly funding cost (or earnings credit).

This method is relatively simplistic, but can be useful in several cases. It can be relatively accurate for smaller balance, higher volume instruments of short term duration. It is a good starting point for relatively meaningful early results during FTP implementation. This technique can be useful for an organization that is new to FTP or one that has not used marginal matched maturity approaches. It is relatively easy to explain and receive “buy-in,” which is often desirable politically.

Strip Balance Weighting

The strip balance weighted method is conceptually similar to the simple average, except that the various rates corresponding to each principal cash flow period are weighted by the principal cash flows (or “strips”) that occur for each period as illustrated on the next page.

A rate of 7.594% would be applied to the average balance of a one-year instrument each month to compute the funding cost (or earnings credit). The results differ from the simple average very slightly because the rates during periods of larger cash flow receive greater weight in the computations. For example, the FTP rate of 7.70% in period 12 receives a weight of 8.33% or 1/12th under the simple average approach. The strip balance weighting approach, however, gives the 7.70% a weight of 8.79% ($87.96/$1,000.31). The results of the two approaches diverge for instruments with longer terms and different payment patterns.

Duration Weighting

Duration weighting is the third method of applying Marginal Matched Maturity FTR With this approach, the rate that corresponds to the duration period of the instrument is used as the FTP rate using this formula: With a duration calculation an instrument that pays back principal over time is equated to an instrument that would receive its principal cash flow at one point in time (i.e., a “bullet’ instrument). For example, the following one-year loan behaves like a “bullet” instrument with a term of 197 days (about 6.47 months). Therefore, the interest rate at the 6.47 month point along the yield curve would be the appropriate FTP rate for this instrument. Using the rates from the preceding two examples, the rate at 6.47 months would be interpolated as 7.5890/o.5

Using duration weights to determine FTP rates needs to be done very carefully. The assumption of a discount rate to compute the present value of principal cash flows is critical to the results as illustrated on the next page.

By using a different discount rate assumption, the same mortgage loan can be viewed as anywhere between a 118-month to a 179-month bullet maturity instrument. Selection of the discount rate is, therefore, crucial.

Many banks will use the stated coupon yield on the instrument as the discount rate. Therefore, as interest rates rise, a given instrument will have a shortened duration, which generally reflects reality.

Median Life

The fourth common method for applying Marginal Matched Maturity FTP is to use the rate that corresponds to the point at which half the principal balance is repaid as shown on the next page.

In this example, a $1,000 monthly payment fully-amortizing loan at 12% repays half of principal in 6.18 months. Using this point on the adjusted FTP rate index curve, in the preceding example, provides an FTP rate of 7.584%.

Comparison of Four Methods

The four approaches to marginal matched maturity FTP provide similar, but not exactly the same results in all cases using the same rate and cash flow assumptions as follows: Generally, the results will vary more substantially for instruments with longer cash flows (i.e., over two or more years) and the more the yield curve slopes upward or downward over time.

The procedure used should reflect the nature of the instrument, the bank’s ability to implement, and the systems in place to calculate the FTP rate.

Other Approaches to FTP Rate Selection

So far we have discussed methods of selecting the FTP rate from the adjusted FTP rate index curve for instruments with known repricing characteristics. Instruments that do not have a contractual repricing period require FTP as well.

Other approaches for selecting the “best” FTP rate for instruments where the maturity or repricing dates are unknown or Marginal Matched Maturity FTP is not required are:

* Specific Matched Rate, and Moving Average Rate.

Specific Matched Rate

The specific matched rate approach is typically used for large individual commercial or government instruments where the bank’s treasury department has entered the market to secure a specific rate at a specific term for a particular contract. The rate plus any necessary adjustments for internal processing is matched to the specific instrument and no Marginal Matched Maturity FTP is required.

Moving Average Rate

The moving average rate assignment approach is used for instruments that do not have a stated maturity, rate index, or repricing period and cannot be accounted for by Marginal Matched Maturity FTP. Examples of these instruments include savings, demand deposit accounts, credit card loans, commercial demand loans, and lines of credit.

For these types of instruments, banks typically compute the weighted moving average rate of, say, 60-, 90-, 180-, and 360-day money, and use this single rate as the FTP rate for a group of similar instruments.

Selecting the “best rate assignment practice” involves tradeoffs between level of precision required for decision making and operational considerations as we shall see in Section IV.


Once the “best” FTP rate has been determined, the next policy issue is selecting the balance against which that rate will be applied to calculate the FTP charge or credit.

Four key policy issues affect the FTP balance selection decision:

Level of balance detail

* Gross versus net balance funding

– INTRA MONTH balances funding

Strip balances funding.


The level of detail is probably the most basic decision, and there are two primary options:

1) Balance Pools – grouping of instruments by some common characteristic

2) Individual Instruments – each instrument is accounted for individually Balance Pools

Balance pools can range from a single pool to many pools, based on characteristics the instruments share, such as contractual maturity date, payment pattern (e.g., monthly payment schedule of even amounts for a fixed rate automobile loan), instrument type (e.g., savings accounts), etc.

The single pool approach treats all instruments the same, regardless of repricing behavior or instrument type. For this reason, it can lead to very misleading results and is virtually never used when computing capabilities allow the bank to use more sophisticated approaches.

The multiple pool approach is a refinement to the single pool approach. Instruments are designated to a pool based on characteristics, such as type of product and maturity date. All balances within a given pool receive the same FTP charge or credit rate. Old and new instruments receive the same rate, which can create swings in calculated margin from month to month.

The multiple pool approach does, however, make sense for some types of instruments, particularly those without stated contractual maturity or repricing dates, such as savings accounts, demand deposit accounts, and credit card loans, or other instruments which do not require individual treatment for customer relationship profitability analysis.

Individual Instruments

Generally, individual instrument funding is required for profitability analysis of large corporate or government customer relationships where individual contracts can have a material impact on the profitability of the financial institution. These contracts are usually identified by a note number or other identifier which drives the particular funding treatment of the individual instrument.


Funding of net balances involves the theory that a given unit in the bank should “fund itself,” then “sell” excess funds or “buy” funds to cover excess assets. Funding gross balances, conversely, implicitly assumes all funds provided are “sold” for credit to the bank’s treasury department and all funds needed are “bought” from the treasury department for a charge. The gross balances funding approach, illustrated on the next page, is more accurate and most often used because it represents the actual practice of a bank where the timing of lending and deposit instruments is never perfect and certain liquidity requirements must be maintained by the bank’s treasury department.

This example illustrates that dramatically different results will be obtained, since the funds generated by the branch unit rarely match their use of the funds. Most banks find the gross balances funding approach to be more useful and accurate because: 1) net balances funding assumes the assets offsetting the liabilities have the same maturity (very unlikely), and 2) it is difficult to apply this approach to detailed product and customer profitability analysis.


INTRA MONTH funding balances represent a degree of precision that is essential for banks which have large-balance, variable-rate instruments. The need arises when an instrument reprises during a month, which gives the opportunity to alter both rate to the customer and the FTP rate. This repricing is typically driven by a change in an external rate index to which the instrument’s yield is tied, such as a change in the prime rate. When the prime rate changes, it is necessary to be able to differentiate the balance before and after the change.

The margin difference can be substantial between INTRA MONTH instrument funding and month-end FTP calculations as illustrated on the next page.

If INTRA MONTH funding is not used, a misleading view is given of the instruments value. The error is even more pronounced if month-end aggregate balance is used instead of the proper average balance.


Strip balances funding is probably the most theoretically correct and mathematically accurate method of computing FTP charge or credit. It is, however, often the most difficult to implement and to explain to line managers and executives.

The concept of strip balance funding is to disaggregate an instrument into its component principal cash flows (the “strips”) and treat each strip as a separate “bullet’ instrument to be funded at the rate effective when that strip is received or paid.

For example, a fully-amortizing loan is made for $1,000 for one year at 12% with twelve equal monthly payments as follows: Instead of viewing this as a $1,000 loan, it can be viewed as a series of 12 bullet loans, each equal to the principal paid in each month. In other words, the bank makes a “loan” for $78.66 in January, a “loan” for $80.37 in February, a “loan” for $80.28 in March, and so on.

The actual funding of these strips involves applying the FTP rate for the month against the amount of the strip. In January, there are 12 strip loans,” in February there are 11, in March there are 10, and so on as shown below:

Once the cost of funding the strips is calculated, the net interest income and margin can be computed as shown below:

The use of the pure strip balances funding approach will result in a computed margin that is erratic, as would be expected, because FTP rates differ by month, days of accrual differ, and principal repaid increases. Nonetheless, it is a precise, mathematically-accurate approach to FTP. Despite the accuracy, the difficulty explaining this to line managers often demands a slight variation to the pure approach.

The variation to the pure “strip” balances funding is:

1) Compute the cost of funding the loan over its entire life using the pure strip balances approach (as shown above).

2) Pre-compute the FrP rate by dividing the lifetime funding cost by the average principal balance outstanding over the life of the loan.

3) Use this rate each month against the principal balance outstanding to compute the funding cost each month.

This will create a constant margin over the life of the loan as shown in the example on the next page (not necessarily the exact accuracy from month to month, but very close and much easier to explain).


So far, we have discussed the policy issues surrounding determination of the FTP rate for a particular instrument or group of instruments and the selection of the FTP balance against which the FTP rate will be applied. Integrating a particular set of FTP policies into a comprehensive management information operation can, however, be a very complex undertaking.

Solid FTP operations require that policy issues be addressed as well, and that the technology be implemented to execute those policies in a cost effective manner. In the past, technology limitations sometimes restricted policy options, often resulting in misleading results.

Past limitations to realizing the full potential of FTP were classified into two broad categories:

1) Availability of necessary data

2) Inadequate computing power.

These limitations caused banks to use high level averages, limited “pools” of funds, and historical rates.

With advances in technology and reductions in computer equipment costs, banks can now implement FTP operations that provide the accuracy and detail necessary for strategic decision making.

Common characteristics of comprehensive FTP operations found at banks worldwide are:

1) Calculate FTP charges or credits at the instrument level, wherever possible, or for groups of homogeneous instruments using multiple pools (i.e., no use of single pool approaches)

2) Allow assignment of FTP rates on any frequency (daily, weekly, etc.) reflecting the rate environment most closely associated with the last repricing date or origination date of the instrument

3) Account for instruments that reprise during the reporting period (i.e., use of INTRA MONTH funding)

4) Isolate profits or losses arising from interest rate risk management in a separate organizational unit

5) Allow FTP rates to differ by product, organizational unit, and/or customer as necessary

6) Enable FTP rates to reflect variations from a standard rate index and various marginal matched maturity techniques

7) Accommodate potentially millions of individual instruments, some funded by specifically matched rates

8) Aggregate FTP results for interface to Asset/Liability Management systems by repricing period and currency.

While considering which characteristics of a sound FTP operation make sense for the financial institution’s management information strategy, bankers should consider two key questions:

1) What do we want from the FTP process?

2) How can we implement FTP quickly for maximum benefit?

1-Source: Council on Financial Competition, 1992 Study.

FTP is used for both assets (funding cost) and liabilities (primarily deposits with an earnings credit). In this article, assets are used as examples in most cases. The same principles apply to liabilities as well.

3 If there is only one rate, like prime or Federal Funds rate, then there is no “curve” and only one time period can be applied against that rate (usually very short term).

Typically, the interest amount is excluded from issues surrounding cash flow, since the funding cost (or earnings credit) determination is driven by the actual principal balances used (or received).

5 A 12% discount rate was used to compute the present value (PV).

By Hogan Systems, Inc. * with contributions from Cole T. Whitney and Woody Alexander

*Reprinted from Journal of Bank Cost& Management Accounting, Volume 8, No. 2. 01995 Hogan Systems, Inc.

Copyright National Association for Bank Cost & Management Accounting 2000

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