Funds Transfer Pricing: No Software Required

There are several misconceptions concerning Funds Transfer Pricing (FTP). One is that it takes a large investment in systems and data to apply the principles. This is simply not true. FTP principles can be applied without any software at all. The following describes several different classes of instruments and how to apply FTP rates for pricing.

FTP rates are used in instrument pricing to represent the marginal cost of raising new money to fund a new loan. Many organizations (About 50%) mistakenly use their internal average cost of funds as the funding cost for pricing loans. That methodology was never a good idea, but organizations could get away with it when interest rates were not moving. That’s no longer the case. For a deeper discussion on this concept see the Kohl White Paper “Internal cost of funds for pricing loans: A bad idea.”

This article does not discuss the rationale for the approaches. That would be too intense for this paper. It simply explains “how” to apply FTP by outlining the basic process for loan and deposit pricing purposes.

First, one should be aware that the fundamental objective of FTP is to assign a funding cost to loans and alternative funding rate to deposits that creates a constant net interest margin for the life of the instrument. FTP does this by assigning a funding rate for loans and an alternative marginal borrowing rate to deposits that removes interest rate risk. For fixed rate items, this means assigning an alternative marginal funding rate with the equivalent average term or duration of the fixed rate instrument.

This concept is very important and should be the basis for all FTP efforts. The concept also removes interest rate risk from the lending and deposit gathering groups. These groups normally have little to no expertise in interest rate risk management so asking them to manage it is unfair. Lenders don’t commonly know what deposit gatherers are doing and vice versa. Only the ALCO group knows this, or at least they should as it’s their job. Next, let’s look at some examples of applying FTP to different types of assets and liabilities.

Fixed Rate Instruments

A classic example is funding a 48-month amortizing item such as an auto loan. That auto loan typically has a constant payment over its life. As such the principal is returned in nearly equal increments each month. This results in the average time to return the principle of around 24 months or ½ the life of the loan (ignoring prepayments). Hence, one would assign the loan a funding cost equal to a 24-month FHLB Advance for the same origination date. This is a standard approach for all fixed rate amortizing instruments.

Matching terms of the loan and funding mitigates the possibility of either rate changing over the life of the transaction. This is how interest rate risk is typically managed. It should be noted that the FHLB advance rates are not the only type of marginal funding available but will be used in this paper for simplicity reasons.

A slightly different approach is applied to CDs. CDs return all their principle at maturity. As such, the average time to return the principle of a 24-month CD is 24 months. There is no averaging because there are no principal payments other than at the end. Therefore, a 24-month CD would be assigned an FTP rate equal to the 24-month FHLB advance rate for today.

Non-Fixed Rate Instruments

Adjustable, administered, or variable rate loans and deposits are handled differently because the rate on the instrument is not fixed. As such, the FTP rate should mirror the driver rate of the instrument. It’s the driver rate that determines the FTP assignment, not principal cash flows. Let’s look at a couple of floating rate examples.

Adjustable-rate mortgages (ARMs) are very straight forward. For a 1-year ARM, the first step is to find the average spread of the 1-Year Treasury to the 1-Year FHLB rate over at least the last 5 years.

One now simply subtracts the spread from the 1-year treasury rate versus 1-year FHLB Advance to determine the current FTP rate for that ARM. This ensures that the ARM will receive a constant net interest margin for the life of the mortgage.

The actual FTP Rate will change over time in concert with the Treasury, which is to be expected. However, the FTP spread should not change as that would introduce interest rate risk (technically basis risk) into the transaction.

Variable rate items like Prime loans are very similar to ARMs with a small twist. Prime loans commonly track the Fed Funds rate which tracks the FHLB overnight rate. So, like an ARM, find the average spread of the FHLB Overnight rate to Prime over at least 5 years. Now subtract the spread from today’s Prime rate and you have the FTP rate for Prime products.

Again, one now simply subtracts the spread from Prime to determine the current FTP rate for that Prime based instrument. This ensures that the instrument will receive a constant net interest margin for the life of instruments like commercial loans and credit cards.

Non-Maturity deposits follow a similar methodology to any adjustable (or administered) rate item. Money Market accounts tend to move closer to market rates so those should be compared to short term rates like 3- or 6-month Advances. Deposits, such as checking accounts move slower, but the rates do move. Those should be compared to longer term advances like a 7-Year advance to the average rate on the non-maturity deposit over the same 5-year time period.  Admittedly this is very subjective, but matching the average life the NMD is on the books is very defendable in absence of a more sophisticated methodology.

The FTP rate is the current rate on the deposit PLUS that spread. Again, for liabilities you add the spread, for loans you subtract it.

An obvious question is probably coming to mind at this point. This spread can change noticeably over time. Welcome to the real world. The spread change is known as basis risk exposure, a form of interest rate risk. Basis risk is something that few lending and deposit gathering groups have any ability to deal with. As such, this should be ALCO’s job to manage as that’s their purpose.

Summary

With today’s interest rate volatility, failing to account for interest rate risk is a major mistake many organizations make when pricing loans and deposits. This approach addresses that. The most noticeable shortcoming of this approach is that it does not go back and historically set FTP rates to instruments already on the balance sheet. This hampers one’s ability to do full profitability analytics on the entire balance sheet as the old, fixed rate loans and deposits won’t have FTP rates assigned to them. That’s what an FTP software solution is for.

The methodology presented in this paper works very well for applying FTP principles for pricing new loans and deposits. It follows basic FTP tenants in that it sets a constant net interest margin for the life of the instrument. It effectively removes interest rate risk from individual transactions and from the lending and deposit gathering groups. Finally, it places that risk with the people most equipped to manage it, the ALCO group.

Appendix: Data and Other Resources

FHLB Des Moines Advance Rate History Tool:  https://www.fhlbdm.com/products-services/advances/rate-history-tool/

FHLB Des Moines Current Advance Rates: https://www.fhlbdm.com/products-services/advances/3/fixed-rate-products/

Federal Reserve Economic Database (FRED):

                Prime Rate History: https://fred.stlouisfed.org/series/PRIME

                1 Year CMT Rate History: https://fred.stlouisfed.org/series/DGS1