12.2 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.

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. Additionally, 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.

Example of Dividing Interest Rate 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 cost 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 - The 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 result 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 the total spread derived from taking Interest Rate Risk can be volatile.