Funds Transfer Pricing (FTP) is a crucial internal financial management tool used by financial institutions to price loans and other financial products. FTP systematically inserts interest rate risk costs into loan pricing by using a marginal cost of funds that reflects current risk and cost of the market. Studies show that nearly 50% of financial institutions do not employ good FTP practices.
A major mistake in pricing loans is that many institutions fail to consider the cost of interest rate risk (IRR.) Institutions would never ignore their number one risk, credit, but routinely ignore their second largest risk, IRR. One of the many functions of an FTP process is that it injects the cost of interest rate risk into the pricing of loans.
Not employing FTP can have significant adverse effects on a financial institution's ability to compete and manage risk effectively. This paper explores four critical consequences of not using FTP: The inability to offer competitive deposit rates, the potential for losses when selling loan production underestimating the value of deposits in acquisitions and the lack of margin to cover hedging costs
1. Inability to Offer Competitive Deposit Rates
Without an effective FTP system, a financial institution lacks a granular understanding of its funding costs. FTP provides a framework for determining the current marginal cost of funds, which is essential for pricing loans appropriately. Without this system, institutions may underestimate their funding costs, leading to the underpricing of loans. This underpricing can strangle their ability to pay competitive deposit rates. If a financial institution cannot offer attractive rates to depositors, it risks losing deposits to competitors, leading to a decline in its funding base. This can create a vicious cycle where the institution is unable to attract sufficient deposits, further increasing its cost of funds and reducing its competitiveness in both lending and deposit markets.
2. Potential Losses in Selling Loan Production
Financial institutions sometimes sell loan production to manage their balance sheet, generate liquidity, or realize profits. The decision to sell loans is heavily influenced by the pricing of these loans. Without FTP, loans may be incorrectly priced, reflecting an underestimation of the cost of funds. When loans are underpriced, the institution may find that the sale of these loans can lead to losses. Thus, the absence of FTP can result in financial losses when the institution needs to sell loan production, as the mispricing will necessitate selling at a loss which can directly impact capital.
3. Underestimating Deposits Value in Acquisition
When loans are priced below a risk-free rate of return the difference must be made up somewhere else to maintain a profit. It is the deposit portfolio that is often where that money comes from. Institutions often mistakenly believe that it is their loans that create value for the institution, but if you can’t sell them at a profit to someone else, are they really profitable in the institution’s portfolio?
Everyone is aware that financial institutions can gather funds substantially below treasuries or alternative funding sources like FHLB advances. When institutions merge, the premium paid is rarely based on the lending portfolio as better yields can often be found in the secondary market (See the previous paragraph.) The acquisition premium is commonly directed at the cheap deposits as those can’t be readily acquired at close to those priced in the secondary market (e.g., FHLB Advances.) As such, it’s deposits that are often subsidizing lending.
4. Lack of Margin for Hedging Costs
Financial institutions use hedging strategies to manage interest rate and other financial risks associated with their loan portfolios. Hedging is essential to ensure stability in earnings and to protect against adverse market movements. However, hedging comes with its own costs. Without FTP, an institution may not produce enough loan revenue to cover both funding and hedging costs. This shortfall can expose the institution to significant risk, as it may forego necessary hedging activities, thereby increasing its vulnerability to market fluctuations and potential financial instability.
Conclusion
In conclusion, the absence of Funds Transfer Pricing in financial institutions can have severe repercussions. Not using FTP can significantly hinder an institution's ability to offer competitive deposit rates, resulting in a weakened funding base. Additionally, it can lead to significant losses if loans must be sold, reducing capital levels. Furthermore, mispricing of loans due to the lack of FTP often results in deposits subsidizing lending. Finally, insufficient margins may hinder an institution’s ability to use hedging to manage IRR. Therefore, implementing an effective FTP system is essential for financial institutions to ensure accurate pricing, manage risks effectively, and maintain competitiveness in the market.