- News & comment
Funds Transfer Pricing – vital to ensuring an effective centrally managed liquidity strategy
Publication date: 15 May 2012
Author: Kent Westerbeck, Westerbeck Risk Management (Courtesy of marcus evans)
Kent Westerbeck, President at Westerbeck Risk Management, speaks about FTP:
Managing a profitable balance sheet is more challenging than ever. With Basel III and the more immediate Dodd-Frank regulation on the horizon, a tool such as FTP is vital to ensure an effective centrally managed liquidity strategy. Post-crisis, whilst the economic situation is improving, allocating sufficient liquidity costs quickly and efficiently to the correct business-line is paramount.
Kent Westerbeck formed the Westerbeck Risk Management consulting company in 2007 after retiring from LaSalle Bank, a subsidiary of ABN AMRO NV. Mr. Westerbeck managed the interest rate risk of LaSalle’s balance sheet and their mortgage servicing rights portfolio and he advised on LaSalle’s transfer pricing process.
FX-MM: Why has FTP become a focus in recent times?
KW: FTP has always been a key to properly pricing products, and evaluating the profitability of customer relationships and business lines within the financial institution.
The importance of these processes has increased as financial institutions face lower profitability levels and the need to respond to current low interest rates and mounting regulatory challenges.
FX-MM: What are the key challenges surrounding FTP and Balance Sheet Management in the current financial environment?
KW: As rates have fallen new product pricing challenges have arisen.
- Rates on non-maturity deposits are near zero but even so, the rates that one can earn when investing these balances have fallen further and the margins on these products have declined. These products frequently have gone from very profitable to unprofitable. This fundamental shift in the profitability of non-maturity deposit products cannot be appreciated unless one properly transfer prices them.
- The current lower rates have generated a lot of customer interest in fixed rate borrowing. Since most financial institutions are in need of fixed rate assets to offset the risk of their non-maturity deposits, this seems like an ideal situation.
Good transfer pricing is needed in order to properly price these new fixed rate term loans.
When good transfer prices are used, one frequently finds that the rates needed on new fixed rate term loans to produce the same profitability as the floating rate term loans they are replacing are very hard to sell to the customers.
So, the bank is faced with the decision to:
- Convince the customer to accept the break-even pricing on the new fixed rate term loans (while competitors without the same pricing discipline may be providing more attractive pricing)
- Accept lower profitability on new fixed rate term loans than they were used to getting from the customer.
- Seek fixed rate term assets needed to manage overall balance sheet risk elsewhere, e.g., in the investment portfolio or through use of derivatives (which present their own issues — accounting challenges and fear of derivatives)
Attaching floors to floating rate loans has helped deal with the issue of falling rates. However, transfer pricing of any instrument that includes an option, like a loan that includes a floor, is particularly problematic.
FX-MM: What areas of FTP and Balance Sheet Management can banks really improve on and how will this help them?
KW: Creating a transfer pricing system where the transfer pricing and interest rate risk assessment are in synch is critical.
When a product’s transfer pricing does not match its interest rate risk assessment, problems will occur. The interest rate risk of the item will direct the interest rate risk manager how to invest (or fund) the product. This will generate profitability that is reflective of the interest rate risk assessment. When the transfer pricing process implies a different risk and a different level of profitability, the institution will mis-assess the true profitability of the product and make poor pricing and product management decisions.
FX-MM: How do you see FTP and balance sheet management developing in the future?
KW: It is very important that the transfer pricing system be a joint venture between the Treasury and the lines of business. Transfer pricing must be established in an open environment where the financial logic of the process can be understood.
Without this open discussion the business lines are likely to feel that the transfer pricing decisions are arbitrary and designed to enrich the Treasury and penalize the lines of business.
Hence the people and committee managing the transfer pricing process must be perceived as intellectually honest and financially sophisticated.
Developing these skills requires training and discussion of the subject with peers.
Note: Kent Westerbeck will be a speaker at the marcus evans Funds Transfer Pricing and Balance Sheet Management Conference, taking place 11 – 13 June 2012 in New York City, NY.
For more information please contact Michele Westergaard, Senior Marketing Manager, Media & PR, marcus evans:
Tel: (001) 312-540-3000 ext. 6625
If you enjoyed this article, why not sign-up to receive our bi-weekly email newsletter?