Recent surveys have indicated that only around 50% of Community Financial Institutions (CFIs) use Funds Transfer Pricing (FTP). Modern CFIs understand that FTP has many uses including as the input for the cost of funding new loan products. Yet there is obviously much resistance to the process.
One of the huge benefits of FTP when pricing loans is that it injects a provision for interest rate risk into the loan rate. This is critical for many reasons including the obvious net interest margin protection from rising rates. It is also critical for liquidity risk management as well priced loans could be sold at PAR or better for liquidity management.
Many CFIs that don’t use FTP for loan pricing find that underpriced loans are worth less than PAR because of the low loan rate. Now the CFI is faced with borrowing money at very high rates or selling loans at a discount. FTP greatly helps alleviate this issue.
Clearly, FTP is a critical tool for CFIs to manage their funding and liquidity risks. However, implementing FTP can face resistance from various stakeholders. Some of the most common resistance points include:
- Data availability: Historical FTP relies on accurate and timely information from various sources such as loan and deposit and market data. However, gathering and integrating these data sources can be challenging, especially if the data is stored in silos or in different formats. This is not an issue if FTP is only used for pricing. FTP can be implemented with no software. Software is only needed if one intends to go back in history and apply FTP rates to loans and deposits already on the books. New loans and deposits can easily be transfer priced with nothing more than spreadsheets
- Impact on loan pricing: FTP can affect the pricing of loans, which may not be well-received by loan officers. FTP allocates funding costs to loans based on their duration and riskiness, which can result in changes to loan pricing. It also prices interest rate risk into the individual loan or deposit. This is a cost that loan officers are not accustomed to recognizing. Loan officers may be concerned that higher loan pricing will make their loans less competitive in the market. So, Is the local lending market smarter than you? Surveys have said no. Surveys indicate that only about 50% of organizations apply FTP principles. Those organizations systematically ignore interest rate risk in their pricing thus underprice loans. This has resulted in the liquidity and interest rate risk issues stated earlier and the failure of some large banks
- Complexity: Transfer Pricing is a complex process that can involve numerous calculations, assumptions, and parameters. CFIs may struggle with understanding and implementing these calculations and parameters, which can lead to errors and inconsistencies in the FTP process. This does not need to be the case at all. Simplified FTP methodologies are highly effective in applying FTP principles. The difference between a weighted average life approach and an individual cash flow methodology is actually quite small. Also, when you take into consideration that cash flows of an instrument are rarely known with exact precision a more precise FTP methodology may not be all that precise in the end. Precision and accuracy are not the same things.
- Organizational structure: It can challenge existing organizational structures within a CFI, as it requires cross-functional collaboration and coordination across multiple departments, such as Treasury, Risk, Finance, and Business Lines. CFIs may face resistance from employees who are not used to working across silos and departments. There are times when specific groups want to measure their performance “their way.” This should not be allowed. Just like the role of the CFO, an independent, unbiased entity should be in charge of performance measurement so that everyone is treated as equally as possible. Don’t let the fox guard the hen house.
- Cultural resistance: FTP can challenge existing cultural norms such as performance measurement and incentive structures. For example, business units may resist FTP if it leads to lower volumes or changes in performance metrics that impact their compensation. The seven most expensive words in business are “we have always done it that way.” Many organizations have used their internal cost of funds as a proxy for the cost to fund loans for decades. That approach appeared to work well in periods of no interest rate volatility but falls apart when rates are changing. Simply put, change is hard for many people.
Overall, resistance to FTP from loan officers can be a significant challenge. CFIs should address these concerns by providing education and training on FTP, ensuring transparency. It is important to align the incentive program to focus on the value of production, not simply the volume.