12 Transfer Pricing Concept

Over the past few decades, financial institutions, such as banks, have evolved as semi-autonomous 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 Funds 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 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 an 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. Additionally, 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 bank balance sheet.

Table 12-1 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 depends on the maturity of the methodology used.

This chapter describes the traditional and matched rate approaches to funds 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.

Topics:

• Traditional Approaches to Transfer Pricing
• A New Approach to Transfer Pricing
• How Matched Rate Transfer Pricing Works?
• Evaluating Interest Rate Risk

• Traditional Approaches to Transfer Pricing
  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 are used either the average or the marginal cost of funds as the Single Transfer Rate.
• A New Approach to Transfer Pricing
  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.
• How Matched Rate Transfer Pricing Works?
  The Treasury often administers the Matched Rate Transfer Pricing. 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, is accumulated at the Treasury level.
• Evaluating Interest Rate Risk
  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 charges for funds (Funding Center Income).