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Funds Transfer Pricing

As we could see in Figure 2 (and recalled in figure 23 hereunder), Funds Transfer Pricing
(FTP) rates are the rates at which commercial units either lend the cash (deposits,
savings,…) they collect to the central Treasury department, or borrow the amounts
needed to extend credits to customers from the same Treasury. In this model of
organization, the Treasury department plays the role of an internal bank, whose clients
are the commercial units. It centralizes all collected deposits and credits extended. Over
the lifetime of each commercial transaction, commercial units will earn the difference
between the rate charged or paid to end customers and the rate they have to pay or will
receive from the Treasury. This difference is called the commercial margin.

Lending Function Financing Function

Kl
Ka

Commercial Ka Commercial
Customers Rcust, l
Unit Unit
Rcust, a
Customers

FTPa Kl
Firms/ Public Entities

FTPl
KF $
KT
Trading Floor Treasury Department
RF
FTPT Capital Markets
KF KI RI
P&LF
$ $

Capital Markets
Capital/ Financial Markets

Capital Markets

Figure 23: Schematic decomposition of capital flows (K) and revenue flows (R, P&L) in a bank

The main objectives of this type of organization & of the FTP system are the following:

 Strip out interest rate risk from the commercial units. The central business of
commercial units is to sell products or gain new market shares, not to manage

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interest rate risk : people working in commercial units & agencies have a marketing
and sales background. They are not capital market professionals. The target
benefit of the FTP system is to provide to commercial units with a fixed margin (the
commercial margin) that remunerates the commercial achievements,

 Centralize within the Treasury the whole liquidity and interest rate risks of the
bank. To the contrary of commercial units, Treasury groups are composed of
capital market professionals, whose job is to anticipate, manage and hedge the
impacts of interest rates fluctuations. Thanks to this centralization, the Treasury
can consolidate all interest rate bearing positions to obtain a total net position,
and can hedge it partially or fully by transacting on the financial markets. The
overall revenue of the Treasury Department coming from this “balance sheet”
management activity is called the transformation margin.

 Allow to measure the profitability of all product lines and commercial units. FTP
rates are therefore an important tool for the management of the bank.

The ideas behind the definition of FTP rates

The general ideas are that the FTP rate must reflect the financial nature of the transaction
the commercial unit is putting in place. As an example, the FTP rate that will be charged to
the commercial unit on a mortgage loan should be equal to the market rate (for the same
maturity) as if the commercial unit would refinance itself direct from the financial
markets. But a question remains: what interest rate curve should be considered? The
sovereign curve? The swap curve? In fact, the rate curve to consider is the one
corresponding to that the bank is working with when it refinances & hedges itself on the
capital markets: the swap rate will therefore be used predominantly31.

This FTP rate has two components:

 a “pure” interest rate component, corresponding to a (default) “risk-free” rate,

 a liquidity component, linked to the bank’s credit risk perceived by counterparties.

Considering the interest rate component only would mean one forgets the bank does not
refinance itself at the “risk free” rate.

Why use a market rate as a reference, when a bank collects “cheap” financing through
customers deposits? The rationale would be that when a bank extends a credit to a client,
the refinancing rate is not the market rate but the average of a/ the rate the bank has to

31
When discussing refinancing rates, ALM professionals will refer to the LIBOR rates for short term
transactions (up to 1 year) and swap rates for longer maturities and use the expression “libor/swap plus X
bps” to speak about the cost of a transaction. This allows to easily compare banks between themselves, in a
very similar way as the CDS spreads.

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pay to depositors, b/ the rate of the long term bonds the bank has issued on the capital
markets. A simple example will show why FTP rate should not be computed this way:

Suppose a bank has the following simple balance sheet:

Assets Liabilities
Amount client rate Amount client rate
Mortgage Loan 120 6% 50 0% At-sight deposits
50 5% Long term debt

20 0% Capital
Total 120 6% 120 2.1%

The weighted average cost of the financing is 2.1%. The net interest income of the bank
over a year is NII  120  6%  120  2.1%  4.7 .

If one uses a market rate of 5% as a reference, the “lending” unit receives 120 x (6% - 5%)
= 1.2 and the “collecting” unit receives 50  (5%  0%)  50  (5%  5%)  2.5 . The
remaining (the transformation margin) goes to the Treasury.

If one uses the average rate of liabilities as a reference, the lending unit receives
120  (6%  2.1%)  4.7, i.e. the whole of the net interest income, and the collecting unit
pays 50  (2.1%  0%)  50  (2.1%  5%)  0.4 to the Treasury although it collects
cheap money from depositors ! The managers of the two commercial units will have very
different opinions on this situation !

Practically, the reference rate must always be the market rate. As we could see with the
previous example:

 FTP rates must always reflect the marginal cost of a transaction and not the
average cost. The question for the bank is whether the new transaction is
profitable or not. By definition, the new transaction is financed at the marginal
cost: when the new loan is extended, it would be “stupid” from the bank to claim it
finances itself with new deposits – the new source of liquidity comes essentially
from the markets. From this marginal cost rationale, the refinancing rate can only
be the market rate.

 Using the market rates as reference is the only way to remunerate fairly the
commercial units in charge of collecting deposits.

Based on the above, it becomes clear how commercial units can increase their revenues :

 Charge rates as high as possible with respect to the FTP rate, in order to have the
highest margin. This is possible only if the commercial units have to latitude to act
on the prices;

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 For products which have a regulated/ managed client rate (and commercial units
cannot modify it), the only solution is to conduce customers to buy the products
with the highest margin. This would the result of an active marketing campaign.

Formal definition of the FTP rates

We just showed above that, based on a simple example, FTP rates should be based on
market interest rates. We will see now how we can come to this conclusion based on a
more formal approach. Actually, the calculation of the FTP rates should follow the
following two principles:

 Principle of no-transfer of marked-to-market within the bank. The marked-to-

market value of the transformation margin must be equal to zero. This follows
from the fact that creation of value from a credit operation comes solely from the
intermediation role of the bank: the economic benefit of this operation must go
the commercial unit.

 Principle of spreading of the margin over time. The first principle above is not
sufficient to fully specify the FTP rate. An additional constraint must be introduced,
which describes how the commercial margin is distributed over time : is the FTP
rate constant ? Is it lowered over time in order to favor long-term oriented
remuneration of commercial units ?...

Applying the two principles described above allows defining the FTP rate on any type of
commercial operation, may it be a loan or a deposit account. To see this, consider an loan
operation started at time t, which is represented by a new production term NP(t ) on the
balance sheet. The amortization function of this operation is Amort(t , T ) .
The first step consists in calculating the market value of the refinancing of the loan, i.e. the
MtM of the transaction between the Treasury and the capital markets: it is represented by
the expectation, under a risk-free probability, of the sum of the discounted cash flows.
One considers that each future balance NP(t ) Amort(t , u) is borrowed at the instant short
term rate r (u ) . The payment cash flow, during the time interval [𝑢, 𝑢 + 𝑑𝑢] is then
NP(t ) Amort(t , u)r (u)du .

Today, this cash flow has the market value:


t NP(t ) Amort(t , u)r (u)du  DF (t , u) ,  (51)

where DF (t , u )  exp    r ( s)ds  is the discount factor. Summing all the future cash
u

 t 
flows, on obtains the market value of future interests on the refinancing:

MtM refi (t )  t  NP(t ) Amort(t , u )r (u )  DF (t , u )du  .


(52)
 t 

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Let’s consider now the cash flows between the Treasury and the commercial unit. For this,
one defines FTPrate (t , u) as the rate component of the FTP rate for new production
starting at date t, NP(t ) . At each future date u , the Treasury receives from the
commercial unit a cash flow equivalent to :

NP(t ) Amort(t , u) FTPrate (t , u)du (53)

The sum of future cash flows is given by:

MtM ftp (t )  t  NP(t ) Amort(t , u ) FTPrate (t , u )  DF (t , u )du  .


(54)
 t 

Following the first principle of non-shifting of market value, the transfer rate FTPrate (t , u)
satisfy the following equation at any date t:

MtM refi (t )  MtM ftp (t ) , (55)

Which is equivalent to:

t  NP(t ) Amort(t , u )  FTPrate (t , u )  r (u ) DF (t , u )du   0 .


(56)
 t 

This equation is a constraint that must be satisfied by the FTP rate, but it is not enough to
fully specify this rate: There is an infinite number of possible definitions of FTPrate (t , u)
that would satisfy this equation. The second principle given earlier is then necessary.

This second principle fixes the time dependence of the margin. There are essentially two
modeling approaches that are typically used:

- A constant Funds Transfer rate:

In this case, one adds the following constraint:

FTPrate (t , u)  FTPrate (t ) , (57)

i.e. the FTP rate is constant over the whole life of the new production. Using equation (56)
above, on gets that

t  Amort (t , u )  r (u )  DF (t , u )du 


t 
FTPrate (t )   . (58)
 
t  Amort (t , u )  DF (t , u )du 
 t 

The major inconvenient of this expression is that if the client rate varies over time (for
example if it is indexed on a market rate), the commercial margin will also vary over time:
the commercial units are not immunized against interest rate risk.

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- A constant commercial margin rate:

In this case, one tries to keep the commercial margin as stable as possible. In doing this,
one gives to the commercial units a long term visibility on their future revenues. Using a
slightly different language: at constant marked-to-market, commercial units prefer to
receive constant revenues. In the present case, the FTP rate is expressed as

FTPrate (t , u)  Rcust (u)  c , (59)

Where Rcust (u ) is the customer rate at time u . c is a constant that can be either negative
or positive.
Expressed this way, the commercial margin is independent of interest rates and time: at
each future date u , the commercial unit receives from customers Rcust (u) Amort(t , u)du
per outstanding amount unit, and pays FTPrate (t , u) Amort(t , u)du to the Treasury. The
difference, c  Amort(t , u)du , represents the commercial margin.
Putting the expression of the FTP rate above in the first constraint equation leads to the
following expression:

 t  Amort (t , v)  r (v)  Rcust (u ) DF (t , v)dv 



t 
FTPrate (t , u )  Rcust (u )   . (60)
 t   Amort (t , v)  DF (t , v)dv 


 t 

This is the representation which is used in the vast majority of real situations. This
expression can look complex, but actually, in well-defined situations, it can be simplified to
converge to an expression much closer to our intuition.

A couple of important examples:

 Bullet loan with fixed rate:

Let’s consider the case of a fixed rate mortgage loan starting in t, with maturity in t  D .
As the customer rate is constant, Rcust (u)  R and the liquidity profile
Amort(t , u)  1(t  u  t  D) is independent from market rates, the above expression for
the FTP rate simplifies to

t  r (v)  DF (t , v)dv 
t D

t 
FTPrate (t )    Rswap (t , t  D) . (61)
 t D
t  DF (t , v)dv 
 t 

 Floating rate deposit account:

If the client rate is equal to the market rate (up to the commercial margin),
Rcust (u)  r (u)  c , the transfer pricing rate becomes : FTPrate (t , u)  r (u) . In the end,

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the commercial unit pays r (u)  c to the customers and receives r (u ) from the
Treasury. The commercial margin is then fully hedged.

 Fixed rate loan with early refinancing option:

Consider that a fixed rate mortgage loan starting in t has a contractual maturity date in
t  D but has an embedded option of early refinancing transferred to the customer. The
modeling of the impact of the option is done through the functional form of the
amortization function Amort(t , T )  Amort(t , T , r (T )) . The expression (61) of the FTP rate
becomes then

t   Amort(t , v, r (v))  r (v)  DF (t , v)dv 

t D

 t 
FTPrate (t )  . (62)
 tD
t  Amort(t , v, r (v))  DF (t , v)dv 
 t 

It becomes generally impossible to express in the simple way the FTP rate as a function of
observable market rates as before. The computation of the FTP rate necessitates either :

- The use of an interest rate model, as would a pricing model (depending on the
choice of this model and of the shape of the amortization function, one could get
a closed form for the FTP rate, but in other cases, Monte Carlo simulations would
be necessary), or

- The use of an approximation of the amortization profile, with the help of portfolio
of bullet transactions with different maturities, replicating the amortization profile
(see figure 24 below).

In this approximation, the amortization function of the loan can be expressed in the
following way:

Amort(t , T )  S (t , T )   w 1 (T  M ) ,
i i
imaturities
i (63)

where the indicator function 1i () applies to the tranche of maturity M i only, and the
weights wi  are the solutions of the following optimization program:

w1 ,..., wm   Argmin Var  Amort(t, T )  S (t, T ) , (64)

wi 0

such that w
i
i  1.

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1 maturity weight
(years) (%)
0.8 1 0
2 10
3 0
Amort(t,T)

0.6
4 10
0.4 5 0
6 10
0.2 7 10
8 20
0 9 20
0 2 4 6 8 10 12 10 20
maturity (years)
15 0

Figure 24: Approximation of the amortization profile of a 10 years maturity loan with constant annuities by
fixed term tranches.

i
Then, using the FTP rate of each tranche, FTPrate , the resulting FTP rate would the simply
be the yield the portfolio that best mirrors the amortization profile, which can be
expressed as:


 w   M  FTP
i
i maturities
i
i
rate (t )  w  M  R (t , t  M )
i
imaturities
i swap i

FTPrate (t )   . (65)


 w M i
i maturities
i

 w M

i
i maturities
i

 Savings accounts with adjustable rates:

In this case, and supposing the dependence of the amortization profile is weakly
dependent on the market rates, equation (60) for the FTP rate becomes:

Amort (t , v)  Et r (v)  Rcust (u ) DF (t , v)dv



FTPrate (t , u )  Rcust (u ) 
 t
, (66)

t
Amort (t , v)  DF (t , v)dv

which implies that we need a model of evolution of the client rate. A replication model,
such as the one described in the previous chapter, is typically used.

Integration of the price of liquidity

To the rate component calculated above, the market practice is to add a liquidity
component : for liability (savings, deposits,…) this component values the fact that the
commercial unit is bringing liquidity to the bank that the Treasury will not have to borrow

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on the market; for assets (loans) this liquidity premium allows to transfer the refinancing
spread that the bank has to pay on the market to the lending commercial unit.
For bullet transactions, it is rather easy to define a liquidity margin: it would correspond to
the credit spread the bank would have to pay for a financing transaction on the capital
markets for an equivalent maturity. Based on this, one can then define a liquidity spread
curve for the bank (see figure 23 below).

50 maturity liquidity
(years) spread (bp)
40 1 1
liquidity spread (bp)

2 13
30 3 27
4 35
20 5 40
6 42
10 7 43
8 43
0 9 44
0 1 2 3 4 5 6 7 8 9 10 11 12 10 45
maturity (years) 15 45

Figure 25: The liquidity spread curve for a bank. The table gives an example of a liquidity spread curve
applicable to all transaction within a bank.

For transactions with non-straightforward amortization profiles, the exact calculation of

liquidity component is more difficult, and one typically adopts a “replication” approach, in
which the amortization profile is approximated by a series of fixed term tranches, as
described in the previous paragraph. In a similar fashion to the definition of the rate
component of the FTP rate (equation), the composite liquidity spread is defined as :


 w   M  FTP
i
i maturities
i
i
liq (t )  w  M  SP (t , t  M )
i
imaturities
i liq i

FTPliq (t )   . (67)


 w M i
i maturities
i

 w M

i
i maturities
i

Finally, the total FTP rate will be the sum of the rate and liquidity components:

FTP(t , T )  FTPrate (t , T )  FTPliq (t ). (68)

A particular case: the Trading Book

As we have discussed in the previous sections, the cost at which funds are exchanged
within the bank between the Treasury and the commercial units needs to be set at a rate
that capture the true liquidity risk of each type of transaction. If these rates set are
unrealistic, there is a risk that new transactions would produce an unrealistic profit for the
commercial unit. Such profit would be the consequence of an artificial funding gain, that
would encourage commercial teams to increase those businesses.

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There actually is empirical evidence of dramatic consequences caused by artificially low

transfer rates. A. Blundell-Wignall and P. Atkinson discuss in a 2008 paper [13] the losses
at UBS in its structured credit business line, which originated and invested in CDOs.
Quoting UBS shareholder report:

“internal bid prices were always higher than the relevant LIBID rate, and internal offer
prices were always lower than the LIBOR rates.”

This means that UBS structured credit business was able to finance deals at prices better
that in the market (implicitly the inter-bank market), despite the fact that it was investing
in assets with a liquidity that was considerably lower than the market. There was no
adjustment for tenor mismatch, as a more realistic funding model was seen as “a
constraint on the growth of business”…
This obvious lack of financing discipline surely played a role in the decision-making
process, as it gave the desk the opportunity to report inflated profits: no standalone CDO
business would ever expect to finance purchases at rate below LIBOR, but rather
significantly above LIBOR (for illustration, the current cost of funding for such assets of
good credit quality is around LIBOR + 150/175bps). With such inflated returns, the desk
could demonstrate very high return-on-capital, which encouraged more risky investment
decisions.

Actually, the UBS case is far from being the exception. The Bank of International
Settlement published in December 2011 an occasional paper in which the result of a
survey on banking funding practices are analysed [14]: Looking at 38 banks in 9 countries,
this survey shows that banks’ fund transfer pricing practices are largely deficient. Most
frameworks failed to incorporate timely the changes in in actual costs of funds, and
liquidity cushions were way too small to withstand prolonged market disruptions & were
comprised of assets that were thought to be more liquid than they actually are. Overall,
the shortcomings encouraged risk maturity transformation, without regard to the
structural liquidity risk that was generated:

“Probably the most striking example of poor FTP practice was how some of the banks that
were surveyed treated liquidity as a free good, completely ignoring the costs, benefits &
risks of liquidity. This was particularly the case the case for much of the contingent or
unfunded businesses that were written. Examples included trading and investment banking
activities & the need to prepare for collateral calls …”

The Marked-to-Market valuation of the Trading Book introduces a number of challenges/

questions when it comes to the funding question, and the nature of each trade has its
importance:

 For cash securities (i.e. funded positions like equities, bonds, structured credits…)
and funded derivatives (options, funded swaps…), the trader has to borrow from
the Treasury to finance the purchase of the security. A reasonable approach to
determine the maturity of the financing would be to consider that the position’s
lifetime is given by M  max subjective _ maturity , contractua l _ maturity  , where

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the subjective maturity used here corresponds to the expected economic life of
the position.

 For unfunded derivatives (swaps, forward contracts, futures…), one could naively
believe that such contracts do not generate liquidity needs and just impact the
P&L account of the bank through their present value. This unfortunately ignores
that in such transactions, one of the parties is carrying counterparty risk
(depending on the sign of the position’s present value32), as the other party may
default by the time the contract matures. This default risk is mitigated by seeing
the party that is “In-The-Money” receiving collateral from the other party. This
collateral is typically provided under the form of cash or low-risk liquid securities,
such as Government bonds33 and obviously has to be funded; i.e. there is a
financing cost associated to it: a FTP rate charged by the Treasury. Still, a couple of
very important questions remain: (1) what is the true present value of a contract
(i.e. what type of interest rate curve should be used for discounting) ? and (2)
what happens when the collateralization process shows “friction”, i.e. is
imperfect?
These two questions are the topics of a current heated (and still unresolved)
debate in the banking risk community, as they have quite practical and
contradictory implications in terms of day-to-day liquidity management (how
much collateral has to be provided and by when?), as well as regulatory and
accounting reporting: this is the CVA/DVA/FVA34 controversy which stems from
the observation that, since 2007, banks can no longer consider that liquidity is a
“free good” and that the default of a large bank can actually happen.

The potential impact of the Liquidity Buffer

Liquidity risk management best practices, as well as regulations (with Basel III, finally) are
requiring from banks that they hold a portfolio of liquid assets (actually mainly high rated
government bonds), so banks can withstand periods of disrupted markets or b difficulties
in refinancing their businesses by selling those assets. Further, this portfolio of liquid

32
The party for which the trade has a positive present value (PV>0) is said to be “In-The-Money”. The other
party, for which the trade has negative present value (equal to -PV), is said “Out-Of-The-Money”.
33
For OTC contracts, the associated terms and conditions are described in the ISDA agreement, and the
collateralization terms and process (i.e. collaterals eligible and collateral exchange conditions) are described
in an associated document, the CSA (Credit support Annex). For standardized exchange traded contracts, the
Exchanges specify the terms and conditions in their contracts descriptions and margining process definition.
34
CVA stands for Credit Valuation Adjustment, the additional capital charge banks have to assess to account
for counterparty risk in the Trading Book (i.e. the risk of default of other parties). DVA stands for Debt
Valuation Adjustment and considers the fact that the bank represents a default risk from the other parties’
perspective, and therefore should come in deduction to the CVA. FVA means Funding Valuation Adjustment
and is sometimes used equivalently to DVA, but not always…

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bonds has to be funded by long term debt (so a liquidity “reservoir” or buffer is created).
This has an obvious negative impact on the profitability of the bank as this long term
funding has a cost higher than the return generated on the government bonds.
So the following question arises: Should the cost of this liquidity buffer be charged back to
the commercial units, and ultimately to the clients, with an additional contribution to the
FTP rate? There is actually no consensus on the answer in the industry, and the choice
made is very much bank specific:

- Some see this cost as a “cost of doing business” imposed by external stakeholders.
Therefore the bank’s senior management, or at least the ALM function, should
bear the cost.

- Others think that this additional FTP component should be charged to commercial
businesses. But a final difficulty remains with the methodology to be applied for
the calculation of this rate: it will depend on the respective size of the transaction,
the liquidity buffer and the bank’s balance sheet. Furthermore, should deposits be
charged as well, as only a fraction of them can be considered as sticky (i.e. long
term)?

Concluding remarks

As we could see, FTP rates have been introduced to fix the prices of the exchanges
between the bank’s Treasury and the commercial units and hence to allow an efficient
management of these commercial units: they are now immunized against the liquidity and
interest rate risks, and can concentrate on their commercial actions. Liquidity risk and
interest rate risk are centralized with the bank’s Treasury.
FTP rates should be based on market rates, and are computed along two guiding
principles: there should be no transfer of MtM between commercial units and the
Treasury (the economic benefit of the commercial effort belongs to the commercial units),
and commercial margin should be as stable as possible (commercial units must have a
long term visibility on their margins). A new production is by definition the result of the
efforts of the client facing teams, and this effort must be compensated by the net revenue
of the departments. FTP rates are viewed as the references on which all compensations
are calculated.

Still, a number of theoretical and practical questions remain open, in particular those
related to the funding of the Trading Book. Maybe the regulatory evolution, forcing the
separation of capital markets activities from the traditional commercial banking
businesses will bring a practical answer.

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