This chapter describes the transfer pricing concept and the traditional and matched rate approaches to transfer pricing. A description of how matched rate transfer pricing overcomes the shortcomings of the traditional approaches is also provided. The chapter ends with a description of the role of matched rate transfer pricing in the evaluation of interest rate risk.
This chapter covers the following topics:
Over the past few decades, financial institutions, such as banks, have evolved as semiautonomous lines of business. Consequently, management requires separate income statements and balance sheets for each line of business to assess its performance. However, creating separate income statements and balance sheets requires the division of the net interest income among the business units. Oracle Transfer Pricing fulfills this need. Transfer pricing is a mechanism for dividing the net interest income of a financial institution (such as a bank) among its constituent business units (such as the deposit, treasury, and the credit groups).
Transfer pricing makes use of transfer rates to divide the net interest income into manageable components by separately identifying the spread earned from interest rate risk and the spread earned from risks managed by the lines of business such as credit risk. The transfer rate for funds is an interest rate representing the value of those funds to a financial institution, that is, the interest rate at which the financial institution can buy or sell those funds in open market.
The transfer rate provides a benchmark for determining whether the yield on a loan (an asset), is enough to cover the associated credit risk and operating cost, besides the cost of acquiring the funds. In addition, a transfer rate for funds allows you to compare the total cost of each source of funds, such as deposits (a liability), to other funding opportunities, for example money or capital market funds. In effect, you use a transfer rate to measure the profit contribution of an asset or liability.
The following table shows a typical bank balance sheet.
| Asset | Liability |
|---|---|
| Less Transfer Cost of Funds/Spread on Assets | Less Cost of Funds/Spread on Liability |
| Less Operating Cost/Profit Contribution | Less Operating Cost/Profit Contribution |
Most large banks have recognized the value of transfer pricing and it has been a part of their performance measurement systems for years. However, the gains from adopting a transfer pricing framework depend on the maturity of methodology being used.
Banks following the traditional approaches to transfer pricing applied a single transfer rate to the net volume of funds generated or consumed by a business unit. They generally used either the average or the marginal cost of funds as the single transfer rate.
Until the 1960s, banks generally used the average cost of funds as the single transfer rate, primarily for loan pricing. If the yield on a loan was higher than the average cost of funds, banks believed that the loan had a positive spread and made the loan.
Over time, the problem with this approach became obvious. Regulated low rate deposits, such as Demand Deposit Accounts (DDA) and Savings Accounts, held the average cost of funds for many banks at a level well below the cost of the new funds. As a result, spreads on new volumes were nowhere near what had been expected. Moreover, the low average cost of funds tempted many banks to underprice loans, sometimes to the point where the true spreads on new volumes were negative.
Consequently, even a stable rate environment was potentially dangerous for banks using the average cost approach to transfer pricing because the balance sheet could grow while earnings dropped.
Recognizing that the use of an average cost of funds could result in unprofitable growth, most banks concluded they should use a transfer price reflecting their real cost of incremental funds. Typically, these banks used the cost of 30 or 90 day certificates of deposit (CDs) as the cost of marginal funds.
The shortcomings of the transfer pricing approaches that advocate the use of a single transfer rate are:
Potential for Inadvertent Unprofitable Growth: Banks assumed that using the marginal cost of funds would make it almost impossible to add volume at a negative spread. This is a fair assumption but it only applies to times when interest rates are stable.
Rate Risk Trap: The single, marginal funds transfer rate led some financial institutions into a rate risk trap. In the 1960s and 1970s, because the yield curve was normal, long term assets offered the largest spreads against a 30 or 90 day transfer rate. So some banks, and almost the entire savings and loan industry, borrowed short and lent long. Interest rates skyrocketed in 1979 and into the 1980s, and consequently the margins disappeared.
Loss of the Credibility of Performance Measurement Systems: Most banks were able to avoid the extreme interest rate risk exposure, which nearly destroyed the savings and loan industry.
However, the use of a single marginal transfer rate undermined the credibility of performance measurement systems. Most line of business managers found that their bottom lines fluctuated wildly with interest rates. Since market interest rates were obviously beyond the control of line managers, they increasingly viewed profit goals for their units with skepticism.
Loss of Managerial Value: The traditional approaches failed to offer any generally accepted (or politically acceptable) method for determining the net interest contribution of the different business units of a bank. Consequently, business unit profitability reporting lost its managerial decision-support value.
In summary, the traditional approaches to transfer pricing were acceptable when interest rates were stable. However, they lost most of their decision-supporting value once rates became volatile.
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As the shortcomings of the traditional transfer pricing systems became obvious, the financial services industry began to search for alternatives. The best solution was developed and implemented by a few leading financial institutions in 1979 and 1980. This approach, called matched rate transfer pricing, uses multiple transfer rates. Assets and liabilities are given transfer rates that reflect their specific maturity and repricing characteristics.
Matched rate transfer pricing resolves the problems inherent in traditional methodologies by:
Clearly showing whether new volumes have a positive spread by using a marginal rate. This eliminates the potential for inadvertent unprofitable growth.
Identifying potential rate risk traps in advance using a marginal rate. In addition, the exposure of a bank to interest rate risk is identified and measured in a manner that makes it easier to manage.
Ensuring that the performance measurement system is consistent, fair, and credible by using a transfer rate that reflects real funding opportunities currently available to the bank.
Matched rate transfer pricing achieves these objectives by dividing the interest rate spread into three components: credit spread, funding spread, and rate risk spread.
Suppose a retail financial institution, a bank for example, relies on a retail customer base for low cost funds that have interest rates lower than funds purchased in money markets. It uses these funds to make loans that have a yield much higher than what the financial institution would pay for funds having the same maturity.
Consider a consumer loan, that yields 200 basis points higher than what the financial institution would pay for funds having the same maturity. Suppose the bank decides to fund the loan with matched maturity funds, say, certificates of deposit that costs 100 basis points less than similar maturity funds purchased in money markets. Then, the bank will have a total interest rate spread of 300 basis points.
Matched rate transfer pricing divides this interest rate spread as follows. While the loan yields 200 basis points more than matched funding costs (transfer rate), the funds cost 100 basis points less than other alternatives (transfer rate). Therefore, the total spread of 300 basis points is the sum of a funding spread (transfer rate - cost of funds) of 100 points and a credit spread (yield on loans - transfer rate) of 200 points.
However, if the financial institution funds the consumer loan with shorter term deposits, then the spread would be larger than 300 basis points. The added spread results from taking interest rate risk (borrowing short and lending long) and is called rate risk spread. The three components of the interest rate spread can be seen by plotting the loan and deposit against the yield curve. However, the portion of total spread derived from taking interest rate risk can be volatile.
The main advantages of matched rate transfer pricing are as follows:
Stabilization of Business Unit Margins: The use of multiple matched transfer rates stabilizes the margins of the different business units. Since assets and liabilities are either funded or sold to transfer pools with corresponding maturities or repricing periods, swings in interest rates do not affect the spread. In addition, the division of the interest rate spread into credit, funding, and rate risk spreads ensures that the bottom line for a business unit reflects only that business and is within the control of the line management.
Decision Support: Under the matched rate transfer pricing approach, the bottom line for a business unit is a fair basis for its performance measurement and management. For example, if some types of loans consistently fail to cover the cost of funds, operating costs, and the credit risk, there is no reason to make those loans. It would be more profitable to buy bonds, or to find other, more profitable lending opportunities. This is the reason why many banks no longer make small installment loans.
Similarly, if the operating costs of gathering low cost consumer deposits are too high, it may be more economical to purchase funds in money markets. This explains the growing number of branch closures, as well as the imposition of increasingly higher minimum balances on some types of consumer deposits.
Identifying Exposure to Interest Rate Risk: Using matched rate transfer pricing, banks can identify their exposure to interest rate risk and its impact on their current earnings. In addition, the banks can isolate the spread from rate risk exposure from their total spreads. This helps them clearly determine the profitability of their business units. Also, banks have found that the interest rate risk becomes increasingly manageable when isolated in a separate business unit. Under the matched rate transfer pricing approach, the rate risk exposure, and its impact on current earnings, is revealed in a new profit center called Treasury. See: How Matched Rate Transfer Pricing Works.
In summary, matched rate transfer pricing works well even when interest rates are volatile. It provides an approach to performance measurement that meets the decision making needs of both line managers (consistency, fairness, controllability) and executive managers (accuracy, flexibility). The financial services industry has recognized these benefits. Consequently, there is an increasing number of financial institutions that have either implemented, or are in the process of implementing performance measurement systems based on matched rate transfer pricing.
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Matched rate transfer pricing is often administered by the Treasury. The Treasury conceptually buys the funds from the deposit gathering group and sells them to the credit group.
Line officers get a rate quote representing either the cost of the funds they want to lend, or the value of the deposits they are gathering. The spread between this quoted rate and the interest rate on the asset or liability is fixed at a known level and maintained for the life of the asset or liability. Any fluctuation in this spread, whether caused by changes in the asset or liability yield curves or in the funds transfer yield curve, gets accumulated at the Treasury level.
The Treasury can manage the fluctuation in the spread in several ways, for example:
Maintain a discretionary portfolio of assets and liabilities with the sole purpose of offsetting the risk that has been transferred from other business units.
Use off-balance sheet transactions, such as swaps and futures, to hedge risk.
Matched rate transfer pricing requires more accounting discipline than traditional transfer pricing approaches. However, it is a straightforward process and is applied in a logical manner, using standard principles of dual-entry accounting.
Suppose a line officer wants to make a loan, and is trying to decide on its pricing. The line officer is given a cost of funds that reflects the maturity and repricing characteristics of the loan. If it is to be a long-term, fixed rate loan, the bank quotes the cost of the long-term funds that can be used to match that loan. Conversely, if the loan is to be short term, the line officer is quoted a short-term rate.
If the yield curve is normal, the transfer rate for a short term loan is less than the rate for a long-term loan. The line officer then figures out how to price the loan to attain a target spread over the quoted cost of funds.
When the loan is booked:
The business unit of the line officer books a shadow liability equal in volume to the size of the loan, having a cost that equals the transfer rate that was quoted. This accounting transaction balances the books of the business unit, and locks in a spread as long as the loan stays on the books.
The books of the corporation must be balanced. Banks do this by creating a shadow asset with equal size and rate to the shadow liability. This shadow asset is housed in a separate business unit, usually Treasury.
The same type of accounting is applied to liabilities also. This type of accounting divides the bank's profits into three components: lending profit, deposit gathering profit, and rate risk profit. These three components add up to the total profit of the bank.
To sum up, under the matched rate transfer pricing approach, banks attach a matched transfer rate to an asset or liability when it is booked, using a standard, double-entry accounting approach. This transfer rate remains constant over the life of the asset or liability, stabilizing the spread for the line of business.
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Matched rate transfer pricing divides the net interest income of your institution into three components: lending, deposit, and the rate risk profit (or loss). The rate risk profit is derived by subtracting all credits for funds (funding center expense) from all charge for funds (funding center income). See: How Matched Rate Transfer Pricing Works.
A net positive number implies that part of your interest margin is a result of any rate bets (or rate risk) your institution has taken. A negative number implies that you have incurred a loss due to rate risk.
The total rate risk profit (or loss) figure is made up from two sources:
Current Rate Risk Profit: The result of rate risk inherent in your current exposure. You can actively manage this profit through effective Asset/Liability management.
Embedded Rate Risk Profit: The result of interest rate bets. You can no longer manage this component of earnings because the relationships are contractual. All you can do is to wait it out.
Suppose a bank, on day one, raises $1,000 in the form of a one-year certificate of deposit at 4%. If the wholesale (open market) alternative to one year funds costs 5% then, the matched transfer rate is 5%.
The bank then lends the $1,000 in the form of a five year nonamortizing (bullet) loan at 10%. If the cost of five-year wholesale funds is 8% then the matched transfer rate for five year funds is 5%.
This table shows the components of the bank's interest rate margin on day one:
| Income Statement Component | Rate | Transfer Rate | Spread |
|---|---|---|---|
| Asset | 10.00% | ||
| 8.00% | |||
| 2.00% | |||
| Liability | 5.00% | ||
| 4.00% | |||
| 1.00% | |||
| Funding Center Spread | 3.00% | ||
| Net Interest Margin | 6.00% |
Over the next year, interest rates rise by 200 basis points. Now, the bank, eager to eliminate future rate risk, issues a new four-year $1,000 CD at 8.5%. However, the four-year transfer rate is now 9.5%.
This table describes the components of the interest margin for the bank after one year:
| Income Statement Component | Rate | Transfer Rate | Spread |
|---|---|---|---|
| Asset | 10.00% | ||
| 8.00% | |||
| 2.00% | |||
| Liability | 9.50% | ||
| 8.50% | |||
| 1.00% | |||
| Funding Center Spread | -1.50% | ||
| Net Interest Margin | 1.50% |
Although the bank is now perfectly matched from a current rate risk perspective (a four-year bullet loan funded by a four-year CD), it is losing 150 basis points at the funding center.
On day one the bank took a rate bet by funding short. The bet was that one year from the loan origination date, the bank would be able to raise four-year funds at less than the cost of funding the original five-year loan, or 8%. Since the four year transfer rate on day one was 7%, when interest rates went up by 200 basis points the bank got badly hit.
Although the net interest margin of the bank is still 150 basis points, the bank could have locked in a 300 basis point net interest margin for five years on day one if it had not taken a rate bet by issuing a five-year CD.
The loss of 150 basis points on the $1,000 loan is a result of the embedded rate risk taken by the bank. The bank can do nothing to eliminate embedded rate risk, except wait.
Even though nothing can be done about embedded rate risk, it is important to identify the impact of embedded rate risk for planning ahead.
For example, if a bank had a large profit in the funding center owing to embedded rate risk, and was unaware of this, it can be lulled into a false sense of security. That bank might be surprised when this source of profit evaporates.
Conversely, if a bank is experiencing a large loss in the funding center due to embedded rate risk, and it is able to measure it, the bank might choose to wait it out rather than taking drastic and immediate actions.
Measuring Current Rate Risk
You can measure current rate risk by transfer pricing your entire balance sheet as if it were originated today. Everything should be transfer priced based upon its remaining term. Under this method, a five-year CD with one year until maturity would receive the same transfer rate as a three-year CD with one year left.
Measuring Embedded Rate Risk
The total rate risk profit is made up of Embedded Rate Risk and Current Rate Risk.
Embedded Rate Risk = Total Rate Risk Result - Current Rate Risk Result
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