12.2.1 Advantages of Matched Rate Transfer Pricing

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. Additionally, 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 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. Additionally, 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. 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.

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 either have implemented or are in the process of implementing performance measurement systems based on matched rate transfer pricing.