A Layman's Guide to Understanding Funds Transfer Pricing

How does FTP Work?

Funds Transfer Pricing (FTP) is one of the more mysterious concepts for individuals without a background in interest rate risk management for Financial Engineering to understand. For that reason, there is commonly a lot of resistance to FTP from non-financial people. The most common objection is "I don't understand it" and "How does that possibly apply to me." The biggest mistake FTP practitioners make is they immediately launch into some technical explanation which only they have the background to really understand. This paper takes the opposite approach to communicating this subject. We'll discuss FTP in general lending terms by comparing the mechanics of FTP risks to common loan losses.

So, surprisingly to many, both loan loss analysis for loan underwriting and FTP interest rate risk (IRR) analysis are conceptually the same process with different mathematics. When done well, the accounting for the two processes is nearly identical. Here's why.

When a loan is originated, it is assigned an expected loan loss percent called a provision. That provision percent is then multiplied times the loan balance and the resulting amount is put into a loan loss reserve in case there are future losses. If there are actual loses, those amounts are then debited from the reserve to cover actual loses. Over time, the objective is that provision will equal the losses, and everyone is happy. Funny thing, that's how a well-designed FTP system works.  

When an FTP rate is assigned to loans and deposits, embedded in that FTP rate is the equivalent of a loan loss provision (LLP). We'll call it the IRR loss provision (ILP). That ILP is then added to an IRR Loss Reserve to help pay for any future interest rate risk losses. When IRR losses do occur, the IRR reserve is debited to offset any IRR losses. The process is just like loan losses. 

Now, we avoided discussing a lot of technical aspects for clarity purposes. The bottom line is, as lenders and deposit gatherers put products onto the balance sheet, they naturally create interest rate risk. So being that lending people do not usually manage deposit gathering and vice versa, someone needs to manage the interplay between loans and deposits and that is the job of the Asset Liability Management team and Senior Management in general. 

How to Use FTP Analysis

The understanding of which loan and deposit products create value (or destroy it) versus just assuming the loans generate profit can have major implications on numerous strategic decisions. It influences how you price your products, your strategic mix of products (i.e., IRR profile/exposure), which products (loans or deposits) you should be marketing, what type of customers you are trying to reach, how you align your operational personnel to serve those targets, the software systems you choose, etc. Understanding what elements of your organization create or destroy value should be the powerful input of your strategic planning process as well as day-to-day decision making.

An Interesting Side Note

FTP is not simply the ravings of consultants. As of March 16, 2016, FTP is a regulatory requirement for US banks larger than $100 Billion. These are the "to big to fail" banks and the regulators want a comfort level that the mega banks are not participating in low-margin business lines as those can present grater risks to the FDIC. Forcing these banks to use FTP provides regulators comfort that they are not chasing unprofitable business just for growth purposes. By the way, have you noticed that large banks are minor players in auto lending? If you look at major bank posted auto rates and current auto market rates, the difference correlates strongly to the difference between FTP and one's internal cost of funds.