Understanding Funds Transfer Pricing Rules

The FTP Rate application engine does the following:

• Identifies instruments to process based on the run control parameters and FTP business rules.

  When processing for a reporting period, the FTP Rate application engine processes all active and open instruments whose commitment date or start date is less than or equal to the last day of the accounting period, and whose end date is after the first day of the accounting period.

• Identifies and assigns the funds transfer pricing rule and break funding rule to a new instrument, according to the definitions in the Product Portfolio Definition, Product Setup pages. The information on funds transfer pricing rules assigned to a given instrument is stored in FTP_RULE_TBL. The funds transfer pricing rate for each balance segment is stored in FTP_BSEQ_IN_F00. The information on break funding rules assigned to a given instrument is stored in FTP_BFND_TBL.

• Identifies any funds transfer pricing adjustments that should be calculated for a given instrument, as defined in the funds transfer pricing rules, and stores adjustment information in the FI_IFTPADJ_R00 table.

The FTP Rate application engine identifies instruments requiring an funds transfer pricing rate calculation. First the Cash Flow Generator application engine calculates the cash flows. Then the financial calculator application engine calculates duration measures (such as average life, or effective duration). The FTP Rate application engine then uses the duration measures, along with the specified cost of funds curve, and the start date or commitment date, to obtain the appropriate yields from the interest rate environment. The yield from the interest rate environment is used as the basis for the funds transfer pricing base rate calculation.

There are several types of events in an instrument's life cycle that can initiate repricing:

• When an instrument is new to the system—that is, there is no funds transfer pricing rate record in the FI_IFTPRATE_R00 table for the instrument.

  For many fixed rate types of instruments, the funds transfer pricing rate is set only once, when the instrument is new. The same rate is then applied each processing period.

• For products that have the Reset FTP Rate Each Period option selected on the Financial Calculation Rules page.

  The funds transfer pricing rate is recalculated during every processing period.

• For variable rate products, whose tenor you may want to base on the instrument's repricing frequency.

  When you choose the repricing frequency funds transfer pricing tenor setting (in the Financial Product Definition pages), the funds transfer pricing rate program calculates and stores the next funds transfer pricing reprice date based on the instrument's repricing schedule. The funds transfer pricing rate is automatically recalculated at the repricing anniversary.

• When there is a funds transfer pricing reset event.

  In some cases, you may want to have an external system trigger a funds transfer pricing repricing event.

  You can do this by having the source system and extract-transform-load process generate a funds transfer pricing reset event in the FI_ITRNHST_R00 table for the instrument. The FTP Rate process automatically scans the FI_ITRNHST_R00 table looking for funds transfer pricing reset events with a transaction code of 060, and resets the funds transfer pricing base and adjustment rates for all those instruments.

When processing instruments, the FTP Rate application engine can use the same general stratification rule as the monthly Financial Performance Measurement program (FPM) or a stratification rule specific to funds transfer pricing. The FPM stratification rule usually pools instruments on a monthly basis for cash flow processing. On the other hand, the stratification rule specific to funds transfer pricing allows discrete pooling based on start date or commitment date, yielding a more accurate funds transfer pricing rate for instruments whose rate changes significantly during the month.

Because of the large volumes of data processed by the FPM program, it may be desirable to stratify the instruments into as small a number of pools as possible, to improve processing time. However, for funds transfer pricing rate setting purposes, it may be desirable to run the stratification process so that the pools created are more tightly stratified and stratified on more attributes than are needed for the FPM process. For example, you may pool the instruments based on monthly start date and end date strata, for an FPM run. However, for a funds transfer pricing rate setting, it may be critical to maintain discrete start dates so that the funds transfer pricing rate reflects the rates in effect on the specific start date for each instrument. Because the FTP Rate process only processes new or repricing instruments, the volume of data that it needs to process is much less than the FPM process, and you can typically afford to define much tighter stratification rules for the FTP process than you use for the FPM process.

You define the rules for calculating the base rate using balance segments. Balance segments are a way of calculating the base rate by using a combination of methodologies, yield curves, or terms, for a specific portion of the balance.

Balance segmentation is commonly used for pricing indeterminate maturity products such as demand deposits, savings, NOW, and money market accounts. Historical trends of deposit patterns suggest that balances in these types of accounts consist of both core (stable) and non-core (volatile) funds. Core funds refer to the minimum balances that tend to be retained by the customer on a long-term basis. At the macro level, these funds can be used as a relatively reliable source of medium to long-term funding for the bank. Non-core or volatile funds refer to the remaining balance, which fluctuates over a short time horizon, and should not be priced as a long-term source of funds. When pricing these types of accounts, you may want to calculate the funds transfer pricing rate by assigning a medium to long-term rate for the core segment of funds and a much shorter term rate for the volatile or non-core percentage of balances. You can easily set up a funds transfer pricing rule that enables this type of rate calculation by using the balance segmentation.

One of the goals of an effective funds transfer pricing system is to calculate the funds transfer rate so that the rate is based on the current interest rate structure representing the marginal cost of funds of similar liquidity and maturity. Funds Transfer Pricing enables you to select one of several methods for calculating the appropriate maturity (or tenor) to use for an instrument. The tenor refers to the length of time that an instrument is available as either a source or use of funds.

Set the tenor algorithm when you specify the term calculation code in the FTP Base Rate page. The tenor can be set a number of ways. If the rule is for a ledger account or a position, you are prompted for the rate in which case tenor isn't relevant or you are directly prompted for the tenor. The term, calculation code, is used for products that have a greater number of options for calculating the tenor.

If the tenor is based on the repricing period, there are two possible ways to set the repricing period and the tenor, depending on the characteristics of the instrument: The repricing period can be based on either a periodic schedule (for example, every six months or annually), or a rate change schedule (that is, set to specific dates). In all cases, the tenor is calculated by the difference between the next repricing date and the last repricing date.

If the funds transfer price is based on strip funding, then the projected cash flow for the instrument in each time period is matched with a specific cost of funds rate for that cash flow. The funds transfer pricing rate for the instrument is then calculated by weighting the cost of funds rate for the cash flow in each time period by the term of the cash flow.

There are several methods to transfer price fixed rate products, including strip funding. Strip funding is the most accurate. Strip funding uses the weighted average cost of funds to calculate funds transfer prices. This involves:

1. Calculating the projected principal payments for the underlying instrument.

2. Using those payments to derive a series of matched maturity funding rates.

3. Calculating the overall base transfer price by weighting each of the derived funding rates by the principal payment amount and by the term of the payment.

This approach weighs the marginal cost of funds (funds transfer rate) in each time period by the size of the cash flow of that period (and by the time to recognize the length of time over which a transfer rate is applicable).

FTP Adjustments is an optional page that enables you to identify charges or credits that should be added to the base rate. For example, you may want to calculate funds transfer pricing charges or credits for geographic premiums, liquidity premiums, embedded options, or incentive programs; or you may want to add to a CD yield curve a premium for FDIC insurance. The adjustment rules are used to define either basis point or fixed amount adjustments for ledger accounts, positions or instrument balances; in practice, it is expected that these are used most often for instrument balances. By specifying different ledger event codes, the funds transfer pricing adjustment amounts can be stored in separate ledger accounts than the base rate.

Your choices for adjustment calculation methods set up in the Adjustments page are:

• Basis point adjustment

  Calculates the funds transfer pricing adjustment by applying the rate specified to the instrument or account balance. Adjustment amount is calculated as: basis points/10,000 * balance * number of days in period/number of days in year.

• Fixed amount

  Generates a fixed amount charge or credit.

• Commitment period rate lock

  This option is available for instruments only. It can be used for instruments with a rate lock option for a specific commitment period−that is, the customer has been given a commitment for a loan at the lowest posted rate during the commitment period. For example, on mortgage loans, the customer may be given an agreement on the commitment date that the rate on the loan is to be set when the loan is drawn or advanced (the start date of the loan) based on the lowest posted rate during the commitment period. If selected, the commitment period rate lock option calculates an funds transfer pricing adjustment that is to be used to transfer the risk of rising interest rates during the commitment period from the business unit to the treasury unit. The spread between the minimum posted rate available during the commitment period and the actual posted rate is applied as an funds transfer pricing adjustment. The historical posted rates are stored in the FI_IDX_RATE_F00 table. For example, a loan commitment might be made on January 1, 2000. If the actual start date of the loan turns out to be June 15, 2000, and the rate lock period is not filled in, then the rate lock adjustment is based on the lowest posted rate between January 1 and June 15, 2000. If, however, the rate lock period is set to 90 days, then the rate lock adjustment is based on the lowest posted rate between March 15 and June 15, 2000.

• Derived from yield curve

  This enables you to perform an adjustment based on a defined term and cost of funds curve. This is often desirable for generating term-based adjustments such as liquidity. Or you may want to pass through to your internal customers or analytical processes an explicit adjustment rate charge, rather than a single rate built from a composite curve comprising all aspects of the funds transfer pricing charge. By decomposing the rate into more granular components, you can encourage appropriate decision-making behavior.

• Lookup table adjustment

  This is an alternative that allows you to load base rate adjustments into an FTP Base Rate Adjustment lookup table. A single adjustment rule linked to this table can then be established to replace thousands of rules. The adjustment values can be in dollars or basis points.

The Renewals/Extensions page of the Transfer Pricing Rules component is used to set up the funds transfer pricing rule for an instrument that is renewed or extended. For these instruments, the FTP Rate application engine calculates a new rate using a blend of the old funds transfer pricing rate and the current interest rates charged for these types of products.

For a renewed or extended instrument, the funds transfer pricing rate can be calculated by blending the new rate with the prior funds transfer pricing rate. A renewed or extended instrument is identified by on of the following transaction codes; 020, 025, 030, 040, and 050 on the FI_ITRNHST_R00 table. Two fields are provided on the instrument records to form the links between the multiple instrument records that can be involved for renewable types of products. On the FI_INSTR_F00 record itself, a field is available called FI_PREV_INSTR_ID that identifies the previous instrument ID for a renewed or extended contract.

In the case of a renewal or extension, the extract-transform-load process creates new instrument, balance, and status records that contain the information for the renewed instrument. When the new instrument is created, the FI_PREV_INSTR_ID field may be populated with the old instrument ID and may update the FI_NXT_INSTR_ID field on the old instrument's FI_ISTATUS_R00 record to point to the new instrument ID. The FI_NXT_INSTR_ID field is optional and is provided so that reports and queries can be performed to track the new instrument from the old instrument ID. The FI_PREV_INSTR_ID can also be used to track the old instrument from the new instrument ID. The blended rate adjustment is as follows:

The FTP Rate process determines the renewal rate lock period as follows:

1. It calculates the earliest possible renewal rate period date, that is, the date that is n days prior to the start date on the new instrument record, wheren = number of days specified by theRate Lock Period field.

2. It sets the rate lock period to the period between the earliest renewal period date and the actual start date.

3. It finds the most recent range of dates for the minimum posted rate in effect during the rate lock period.

   The posted rates are the historical rates stored in the FI_IDX_RATE_F00 table according to the price index ID.

The FTP Rate process calculates the funds transfer pricing base rate for renewed or extended instruments using the minimum cost of funds rates in effect during the renewal rate lock period.

The FTP Rate process blends the current adjustment with the previous adjustment based on the following formula:

A new funds transfer pricing rate is calculated for renewed or extended instruments, which are the same as new instruments. The FTP Rate process automatically scans the FI_ITRNHST_R00 table looking for funds transfer pricing reset events with the transaction codes of 020, 025, 030, 040, and 050 and resets the funds transfer pricing base and adjustment rates for all those instruments.