12.1 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.

Until the 1960s, banks used the average cost of funds as the Single Transfer Rate, primarily for loan pricing. If the yield on a loan was higher than the average cost of funds, banks believed that the loan had a positive spread and made the loan. Over time, the problem with this approach became obvious. Regulated low rate deposits, such as Demand Deposit Accounts (DDA) and Savings Accounts, held the average cost of funds for many banks at a level well below the cost of the new funds. As a result, spreads on new volumes were nowhere near what had been expected. Moreover, the low average cost of funds tempted many banks to underprice loans, sometimes to the point where the true spreads on new volumes were negative.

Consequently, even a stable rate environment was potentially dangerous for banks using the average cost approach to transfer pricing because the balance sheet could grow while earnings dropped.

Recognizing that the use of an average cost of funds could result in unprofitable growth, most banks concluded they should use a Transfer Price reflecting their real cost of incremental funds. These banks used the cost of 30 or 90-day Certificates of Deposit (CDs) as the cost of marginal funds.

Pitfalls of the Traditional Approaches

The shortcomings of the Transfer Pricing approaches that advocate the use of a single transfer rate are:

• Potential for Inadvertent Unprofitable Growth: Banks assumed that using the marginal cost of funds would make it almost impossible to add volume at a negative spread. This is a fair assumption but it only applies to times when interest rates are stable.
• Rate Risk Trap: The single, marginal funds transfer rate led some financial institutions into a rate risk trap. In the 1960s and 1970s, because the yield curve was normal, long-term assets offered the largest spreads against a 30 or 90-day transfer rate. Therefore, some banks, and almost the entire savings and loan industry, borrowed short and lent long. Interest rates skyrocketed in 1979 and into the 1980s, and consequently, the margins disappeared.
• Loss of the Credibility of Performance Measurement Systems: Most banks were able to avoid the extreme interest rate risk exposure, which nearly destroyed the savings and loan industry. However, the use of a single marginal transfer rate undermined the credibility of performance measurement systems. Most line of business managers found that their bottom lines fluctuated wildly with interest rates. Since market interest rates were obviously beyond the control of line managers, they increasingly viewed profit goals for their units with skepticism.
• Loss of Managerial Value: The traditional approaches failed to offer any accepted (or politically acceptable) method for determining the net interest contribution of the different business units of a bank. Consequently, business unit profitability reporting lost its managerial decision-support value.

In summary, the traditional approaches to transfer pricing were acceptable when interest rates were stable. However, they lost most of their decision-supporting value after rates became volatile.