12.3 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.

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.

Matched Rate Transfer Pricing Example

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.