Dr.

Judit Burucs is Project Manager, for

IFC, Russian Banking Advisory
Project. Prior to IFC she worked as
the Managing Director for OTP
Group in Budapest. She was
responsible for the Group’s level
managing country, counterparty risk
and market, liquidity, and interest rate
risks.

THOUGHTS ABOUT EMPLOYING FUND TRANSFER PRICING

[Dr. Judit Burucs, April 10, 2008]

Internal Fund Transfer Pricing (FTP) is a well known practice in the financial sector, it is part
of the overall management information, accounting and control system which includes
pricing, budgeting profit planning and asset and liability management.

Through fund transfer pricing a bank can analyze more efficiently its net interest margin,
because fund transfer pricing allows for quantifying the variances caused by imbalance of
funds provided and funds used by the bank. The following types of FTP methodologies are
utilized by the financial institutions1:

1. Single Pool Rate Matching utilizes one rate to credit all fund providers and debit
all fund users, respectively. This rate might be the weighted average cost of funds for
the reporting institution, prime rate, or some other capital market rate. The single pool
approach is simple, but does not take into consideration any maturity or imbedded risk
characteristics.
2. Specific Matching is a mostly academic approach. The objective of specific
matching is to match every specific liability with every specific asset of an equal
amount, maturity and imbedded risk characteristic.
3. Multiple Pool Rate Matching is an extension of single pool rate transfer pricing.
Essentially, each side of the balance sheet is split into pools of assets and liabilities
sorted by criteria such as maturity characteristic, rate and yield, imbedded risk, or
credit factors. Then the pools from each side of the balance sheet are matched to the
opposite side of the balance sheet to establish a related funds charge or credit.
4. Matched Maturity is basically a gap approach. Each individual customer account
is matched to a market driven index such as the Treasury Yield Curve, the swap curve,
or LIBOR (London Inter-Bank Offer Rate) based curve. Transfer pricing rates should
represent the alternative “opportunity” rate for the bank’s sources or use funds and
vary according to repricing term and other attributes.

The Matched Maturity has become the preferred approach to Funds Transfer Pricing because
 Business units are more willing to accept FTP when transfer prices have a transparent,
rational basis and are applied consistently throughout the organizational structure and
across timelines.
 Marginal spread for each product is accurately measured.
 The earning attributable to interest rate mismatching is correctly identified.
 Each product spread is independent of any other balance sheet element.

1
Keys to community bank success: Utilizing management information to make informed decisions-Funds
transfer pricing (FTP) , Journal of Bank Cost & Management Accounting, 2001, by Katafian, Robert E.

1
The main objective of this article is to provide a brief introduction of the Matched Maturity
Fund Transfer Pricing approach, and to highlight the specifics of its application to the
Russian Financial Market.

I. BASICS OF THE FUND TRANSFER PRICING

I.1.The process

FTP creates a shadow2 of assets and liabilities for each expected cash flow item on the
balance sheet and attaches to each a market price respective of its particular terms. Real
assets are accordingly funded by “shadow” liabilities to produce a match–funded spread;
conversely, real liabilities receive income from “shadow’ assets for the same purpose. A
unique charge or credit rate is assigned to each record according to its origination date on the
basis of repricing tenor, contractual cash flow and some adjustment (repricing spread,
liquidity term, embedded option and etc.)

In the process, the lending and deposit units obtain a leveled balance sheet and a net interest
spread per record is established. The FTP posts mismatched earnings from business units into
a special Funding Mismatch Unit. This unit can be the Treasury, Funding Center or ALCO in
practice. The Funding Mismatch Unit acts as the central clearing house for funds,
benchmarking all transfer rates against a market derived yield curve plus other market pricing
factors. Calculated debits and credits are applied to book balances until the earlier of maturity
or repricing. If the bank uses a single yield curve, so asset and liability transactions of
identical attributes are assigned an identical transfer rate. When measuring performance, a
transaction’s transfer rate remains unchanged over its repricing life. Effectively, this insulates
the transaction’s margin contribution from the effect of subsequent market interest rate
changes.

A simple example will illustrate this process. Let us assume that the institution has only two
items on its balance sheet: 3 year duration deposit on which it pays 6,5 % interest rate and a 8
year duration mortgage on which it receives a 10 % interest rate. A net interest margin is 3.5
% (10%-6.5%). Assume further that the bank is asset rich (it possesses more loan than
deposits) and can borrow in the wholesale market at 7 % for 3 years and 8 % for 8 years. The
FTP allows the institution to split up its 3.5 % net interest margin into a 2 % net interest
margin on loan (10%-8%) , a 0.5% net interest margin on deposit (7%-6.5%), and interest rate
risk mismatch of 1 % (8 %-7%).

I.2. Funding curve

Selecting a transfer pricing yield curve is a critical aspect of the FTP. Should we use the
Funding rate or the Investment rate? When implementing a FTP system banks must determine
a “funding yield curve” that most accurately reflects their source or assets on the whole sale
market. Some banks may utilize an interbank rate such as LIBOR, interbank SWAP curve, or

2
A bank’s focal point for market risk: The transfer pricing mismatch unit, Journal of Bank Cost & Management
Accounting, 200 by Chittenden, John

2
a treasury yield curve. Using credit risk free market indices like a treasury yield curve will
encourage banks to make loans that are less profitable than they appear and to discourage
deposits that can be profitable.

Another methodological choice that banks currently face is the decision to apply single or
multiple benchmark yield curves. Mr. Shih 3 proved that while the multiple curves option may
appear desirable at the first glance, the actual use of a multiple curve methodology will have
serious and detrimental consequences for FTP program as misallocation of resources,
inconsistent margin comparisons among products, inaccurate measurement of the total interest
rate risk of the institution and improper inclusion of credit risk in interest rate risk.

Furthermore bank should apply a separate benchmark yield curve to each of the currencies in
which it operates, because each of the currencies in which a bank deals represents a distinct
and independent source of interest rate risk. Interest rate in European Union, Russia or USA
may shift in opposite direction for completely unrelated reasons.

I.3. Adjustment for other factors beyond the benchmark

The funding curve for a financial instrument shows the relationship between different
indicators such as time to maturity and the interest rate. Adjustments to a base FTP4 yield
curve are often necessary to reflect unique attributes of the particular institution and
instrument. The most common adjustment methodologies will be introduced in the following
section. The decision to apply a certain method to use should coincide with the bank’s own
cultural and fundamental principles which are the follows:

1. Institution Credit Risk Adjustment: If the bank is not deposit rich, the base yield
curve needs to be adjusted to reflect the bank’s own credit risk. There are some banks
that use their own actual senior debt market spread.
2. Bid/Asked Spread or Funding Commission Adjustment: The brokering cost
(commission or fee) can be factored into the transfer pricing yield curve. Typical
products for this approach are all assets and liabilities managed by a treasury
department of a bank.
3. Term Liquidity Adjustment: Term liquidity is the impact of the repricing frequency
of an instrument being shorter than expected maturity. The liquidity premium can be
estimated by observing rate differentials between the organization’s wholesale funding
curve and swap curve. Swap rates quote the cost to transfer interest rate risk, so
differences between actual funding rates and swaps represent the cost to raise physical
liquidity, less term repricing risk. For example the market prices fixed rate 90 days
commitments differ from floating rate commitments with 90 day repricing. The
difference is the liquidity premium. Adjustment can be made by debiting a tem
liquidity premium to floating (variable) rate assets based on their contractual or

3
Transfer pricing: Pitfalls in using multiple benchmark yields curves , Journal of Bank Cost &Management
Accounting,2000, by Shih, Andre
4
: Adjustments to the base FTP rate index curve, Journal of Bank Cost & Management Accounting, by Ersoz,
Ali Murat
Transfer Pricing, Financial Risk management in Banking, Therory &Application of Asset &Liability
Management MCGRaw-Hill, by Dennis G. Uyemura, Domald R. Van Deventer

3
 expected –average lifetime and assigning a credit to floating (variable) rate liabilities
based on their contractual or expected average lifetime. The adjustment (specific
amount of the spread) can be made by applying historical rates.
Adjustment to the base yield curve are necessary for instruments that have the same
duration or repricing period, but due to different liquidity characteristics are not of the
same value or cost to the bank. A fixed rate loan with 5 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, by using a secondary market
for securitization.
4. Option Pricing Adjustment: is used to reflect the cost of providing the customer an
right to unilaterally change the contractual terms of a transaction.
5. Prepayment Penalty Adjustment: can be incorporated and applied in transfer pricing
in two ways: The first way is the after transaction that is applicable to larger-sized
transactions, especially where an economic prepayment fee is charged to the borrower.
Transfer rates are assigned based on the contractual amortization or maturity schedule.
When a prepayment occurs, the original transfer fund are sold back to the Treasury
with the mark to market prepayment loss (or gain) passed to the business line unit in
the form of a cost allocation. The second way is for transactions that are used for loan
products where there is generally no prepayment penalty charged. (e.g. mortgage
loan). The FTP is increased by an amount that will compensate the Treasury over the
expected average life of such loans for the prepayments that will occur.
6. Mandatory Reverse Deposit Requirement Adjustment: is the lost interest on the
deposit without interest or lower interest that needs to be held in the Central bank by
the bank.
7. Interest payment Adjustment: The banks should adjust their funds transfer price to
an interest payment frequency. A funds transfer debit or credit adjustment is to be
made for all interest –earning and interest –bearing products which interest payment
frequency is different from the basic yield curve.
8. Others adjustments: can also be made though are not common in practice. Among
them are: Tax Advantage Adjustment for fixed asset in auto or commercial leases, or
Stand by Liquidity Adjustments.

I.4. Adjustment or transfer pricing in the case of indeterminate maturity deposits and non
interest bearing assets

Every source and use of funds does influence the margin. Some are interest bearing, others are
not. Capital, cash and fixed assets are non-interest bearing accounts. According to Randall5
“…after considering the value and relevance of transfer pricing non-interest related balance
sheet positions, in most cases, it's quite a useless exercise. “

5
To FTP Or Not To FTP - That is The Question!, Journal of Performance Management , May 1 2004, By Payant,
W Randall

4
In the case of the indeterminate maturity deposit especially in the case of demand deposits
finding the appropriate FTP is a real challenge and the bank should find it own way. The
current rate6 method, the average rate methods and the blended term approach are well used.
1. The current rate method transfer prices the deposit at rates that are in place for
the current processing period. Changes in market rates are immediately and fully
reflected in assigned transfer rate.
2. The moving average methods, a form of the average rate transfer pricing, intends
to describe the sluggish pricing observed for these types of liabilities. A time
period for the moving average is chosen based on the observed or estimated
repricing responsiveness for the deposit category.
3. Blended term analysis initiates by assuming a portion to a product line as core
stable based on historical analysis of past cash flow patterns in balances. Non
volatile balances profiles secure longer moving averages. Balance and time
segmentation continues until some amount is apportioned to a volatile portion
which receives a short transfer rate. Blended term transfer rate is a weighted
transfer price with cash flow.

I.5. Using the FTP for performance forecasting and measuring branch profitability

The FTP can assist the convergence of the Asset and Liability Management (ALM) and the
budget planning7. Transfer prices can help forecasting 8 margin performance of business
units. Additionally, the residual spread between the interest rate and transfer rates can be used
in simulating funding center strategies and measuring mismatched risk exposure.

Managers want to forecast their business unit’s net interest contribution especially in the
budgeting process. When they project the future balance sheet, they can be assisted by a
simulation tool based on the FTP which models balance sheet and interest income/expense
behaviors, separating the future impact of existing business from planned, new business.

The model needs information about the cash flow, repricing, maturity, currency, embedded
option and other characteristics of existing business. This simulation model provides then
forecast of a business unit’s pre-ordained interest margin based on it existing book of
business. Business unit managers can project the additional new business volumes that must
be booked, at appropriate margins, to meet their overall net interest contribution target. The
business unit’s simulation forecast are rate–environment sensitive, managers can understand
and consider rate-dependent volume effects on their business performance.

The originating unit’s net contribution to the overall recorded margin of the bank is a
traditional historical post performance measurement view. The FTP cannot eliminate all
effects of interest rate changes from originating business units or unscheduled volume
reductions. Rate-volume variance analysis must consider this element. FTP only insulated the
origination unit’s performance from the effects of pricing risk, not volume risk.

6
Transfer pricing Indeterminate-maturity Deposits, Journal of Performance Management, by Thomas E. Bowers
7
Better financial planning with balance sheet modeling, Journal of bank Cost & Management Accounting, 2000,
by Eastburn, Stephen.
8
Fund transfer pricing and A/L modeling, Journal of Bank cost & management Accountant, 2000, Payant, W
Randall.

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After allocating the contribution margin based on transfer prices, any residual spread is
credited to a funding center. This spread is what the bank earned from accepting funding
mismatches. In aggregate, though, sources and uses of funds in the balance sheet create
numerous funding mismatches. The residual spread provides limited information about the
aggregate balance sheet mismatch to which the bank is currently exposed. This is because it is
derived from transfer price assigned at interest rate setting.

To understand and measure the earnings impact on the funding center of the existing
mismatch, transaction’s remaining-term transfer price need to be used. A transaction’s
remaining term transfer price is the price that would be assigned today based on it is
remaining repayment characteristic and today’s alternative yield curve so, the spread between
the different points of the curve indicates how much could be earned for accepting
mismatches today.

To analyze the bank’s aggregate existing mismatches, the remaining –term transfer price is
applied to the transfer –priced principal balances for all sources and uses of funds. The overall
mismatch’s impact on future earnings can be evaluated in an income simulation model. This
procedure isolates only the funding mismatch components in the simulation’s funding risk
assessment. The income simulation of the funding mismatch assists the funding center in its
management. The difference between the origination term and remaining-term simulation
results represents the spread the bank created from two factors- first accepting prior mismatch
exposures, whose effects on earnings may not be felt immediately and secondly because
transaction’s remaining lives shorten over time.

The planning usually focus on a single “most likely“ scenario for interest rates and
assumption such as prepayments while ALM mutually tests the future balance sheet and net
interest revenue projections across numerous and varying assumptions . Income simulation
can be performed with different assumption for interest rates, prepayments, volume growth,
spreads, etc. Rules can be created to automatically calculate new business assumptions based
on other assumption or result. FTP should remove future interest rate risk planned business
unit net interest revenue and yield a mismatch calculation which is very meaningful for a
Treasury department.

Transfer pricing can help to measure and compare the branch profitability9. Branches
within a bank are almost never the same in terms of loans and deposits. Some branches are
rich on the loan side, while others are rich on the deposit side or are fairly balanced.
Determining the profitability of individual branches in a traditional accounting sense is
difficult; because a branch is heavy on the deposit side will look like it is losing money, while
a branch that heavy on the loan side will look like it is highly profitable. However,
determining the true profitability of branch is difficult.

Using the FTP system will charge a cost of funds to all the loans that each branch has and will
give a funding credit to all deposits that each branch has. Management must be cautious when

9
Fund Transfer Pricing: How to Measure branch Profitability, Journal of Performance Management, by Mehmet
C. Kocakulah,

6
looking at the spread is for economic factors in different areas are beyond the control of the
branch manager. For example, Branch A may be in a location that has a number of
competitive banks in its immediate region. To stay competitive and survive in this type of
condition, the branch may be forced to earn lower spread on its loans to bring in new
business. So although FTP allows for easier comparisons between different branches, as with
all management tools, there are other factors that must be considered.

II. WHAT ARE THE SPECIFICS OF USING FTP I NTHE RUSSIAN MARKET?

II.1 Funding curve for ruble denominated assets and liabilities

Selecting a transfer pricing yield curve is a critical aspect of the FTP. This is a challenge for
the Russian market, because there is still no real wholesale market or liquid bond market for
longer maturities than 2-3 years.

If the bank is rich on the deposit side, it can choose an investment yield curve as a transfer
pricing yield curve. The potential investment curve could be the followings:
 The treasury bond yield curve
 Rate of the bonds issued by the Agency for Housing Mortgage Lending10 ("AHML")
because it is also a more or less credit risk free yield curve so far the bonds issued by
AHML are guaranteed by the Government. It is a real option for the mortgage loan
bank if the loan portfolio can be refinanced through the AHML facilities. The problem
with this curve is the lack of sufficient data for short periods (up to 1 year).
Alternatively, for short periods, the bank could use MOSIBOR.

If the bank is loan rich, it needs a transfer pricing yield curve that reflects the bank’s source
and use of the funds on the whole sale market. There is no real good solution in the Russian
market. Consequently the bank could use a special single curve that it derives from several
benchmark yield curve. The possibilities could be the following:
 Rates extracted from Central bank Russia (CBR) refinancing mechanisms included
intraday, overnight, and relatively short-term Lombard and Repo facilities. There are
also longer-term (up to 180-day) facilities available from the CBR for which collateral
is required in the form of promissory notes, rights under the loan agreements and/or
bank guarantees. However, the latter loans are difficult to obtain due to the approval
process and strict collateral requirements, including heavy discounts, and therefore
they remain largely untested.
 Mosprime –Moscow prime offered rate. National Foreign Exchange association began
the index in April 2005.
 Moscow Interbank Offer Rate (MIBOR) based on 31 banks offer rates: from 2 to 7
days, from 8 to 30 days, from 31 to 90 days., from 91 to 180 days, from 181 days to 1
year, but the market for 3 months money is not liquid.

10
The AHML was created by the government in 1997 in order to provide refinancing options for banks. The agency aims to finance itself
mainly by issuing bonds and obligations backed by mortgages. The Russian government is the sole shareholder of the AHML and is
committed to supporting the agency by providing guarantees to the AHML as well as a direct participation in the AHML equity capital.

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  Yield of bonds issued by banks. The bank can choose between the rate issued by state
own banks or average yield of bonds issued by banks that are the same size than the
given bank. The maturity of bonds issued by banks is medium term. However the
domestic ruble bond market is still relatively shallow, with the major investors being
domestic banks and foreign buyers.

The following table shows the potential yield curves in the market.

For example a loan rich bank could use the following yield curves
 For short terms (up to 1 year), the MIBOR average.
 From 1 year to 5 years, the AHML
 For 5 years and longer, the yields from the treasury markets.

II.2 Transfer Pricing Curve for USD and EUR denominated assets and liabilities

Russian bank with assets or liabilities in USD and EUR currencies should use the interbank
swap curve or the whole market yield curve (LIBOR).

II.3. Adjustment to a base FTP yield curve

There are some important adjustment that could be really useful for the banks in the Russian
market too, because it would prevent inconsistent margin comparisons among products,

8
inaccurate measurement of the interest rate risk of the bank, and misallocation of the
resources.

Institution Credit Risk Adjustment: In the case of banks which are loan rich the base yield
curve needs to be adjusted to reflect the bank’s own credit risk. The simplest solution is to
define the difference between benchmark curve (especially the CBR yield curve or treasury
yield curve) and the yield of the bonds that the bank issued, or the margin between the LIBOR
(wholesale price) and actual price in the interbank market that the bank can borrow from.

Term of Liquidity: Russian banks have to use liquidity adjustment for assets and liabilities
denominated in foreign currencies. The liquidity premium can be the difference between the
short term and long term floating rate fund with the same repricing period. Banks recently
have lengthened funding maturities through syndications floating-interest rates borrowings.
Banks are trying to mitigate refinancing risk through diversification of the investor base, both
geographically and by currency, as well as through more active use of securitization. Foreign
currency lending is typically long-term (more than 5 years), so the risk arises from possible
maturity gaps between assets and liabilities denominated in the same currency. Additionally,
as banks expand into the SME and retail segments and in the regions, where there is little
demand for foreign currency loans, those banks with a large share of foreign funding may
have significant on-balance-sheet currency and interest rate mismatches. Banks tend to match
foreign currency assets and liabilities, with the foreign exchange risk being passed on to
borrowers. For Russian banks with assets and liabilities denominated in ruble bearing fixed
rates and with short deposit tenors, there is no need to apply liquidity adjustments.
Bank should use the liquidity premium in the case of corporate bonds that are freely traded.
These bonds have been broadly used by smaller banks, both as a source of credit exposure to
and interest income from larger companies, and for liquidity management purposes.

Mandatory Reserve Requirements: To reduce banks’ risk exposures and to manage liquidity
in the banking sector, banks are required to place non-interest-bearing reserve deposits with
the CBR. From 1 July 2007 the rate is 4.5 %, but only 4 % for retail deposits.

Prepayment penalty: Banks having retail deposits or having retail loans should apply
prepayment adjustment. These can be withdrawn on demand, incurring the penalty of
foregoing earned interest; their potential flightiness has been partially mitigated, though, by
the introduction of the deposit insurance system.

Option Pricing Adjustment: The banks should use option pricing adjustment, where loan
agreements contain a clause allowing banks to re-price customers’ loans, however this option
is only likely to be used in an extreme scenario and would be likely to give rise to significant
customer relationship issues.

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The following table shows all Adjustments to the base FTP yield curve

Adjustment to the FTP rate in RUB

Product s Institution Credit Term Liquidity Prepayment Mandatory Interest payment Funding
Risk ( loan rich penalty reserve or principal commission
bank) payment
Assets YES
Money Market assets ( YES If it does not fit to YES
treasury) yield curve
Prime based Commercial YES over 1 year If it does not fit to
loan yield curve
Money Market rate YES over 1 year If it does not fit to
indexed Commercial yield curve
Fixed rate commercial YES If it does not fit to
loan yield curve
Fixed rate mortgage loan YES YES If it does not fit to
yield curve
Floating rate consumer YES over 1 year YES o If it does not fit to
loans yield curve
Adjustable rate mortgage YES over 1 year YES If it does not fit to
yield curve
Prime or variable rate YES over 1 year YES If it does not fit to
consumer loan. yield curve
Indeterminate –maturity YES weighted/ or If it does not fit to
assets nothing yield curve
Liabilities YES If it does not fit to
yield curve
Money market dep. YES If it does not fit to YES
yield curve
Retail Current account YES 4% If it does not fit to
yield curve
Retail deposit floating YES over 1 year 4% If it does not fit to
rate yield curve
Retail deposit variable YES over 1 year 4% If it does not fit to
yield curve
Retail fix rate deposit YES 4% If it does not fit to
yield curve
Floating corporate YES over 1 year 4,5% If it does not fit to
deposit yield curve
Indeterminate maturity YES weighted/ If it does not fit to
deposit nothing yield curve

III. SUMMARY

FTP is a powerful tool available to management for profitability analysis and comparison
among business lines, product and branches of various sizes. It allows management to make
informed decision on product pricing. It helps in forecasting the individual business units’
performance and to measure the effectiveness of the funding center’s asset and liability
management.

The banks need a comprehensive FTP or ALM system with appropriate IT support. There are
several IT companies that provide financial institutions with sophisticated ALM software that
includes transfer pricing model. Installing these models is more expensive, but fast option
and gives a bank a additional know-how. We encourage banks to look into FTP. Please note,
likewise any management tool. FTP should not be utilized to the exclusion of all other tools
and methods of analysis and decision making.

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