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Funds transfer pricing system is a major tool available to assist in enhancing profits. Profitability, rather than growth, has become the key to success in today's banking world. Shareholders are demanding higher returns and pressing for fast results. Banks have been responding to these pressures by expanding the types of financial instruments, and financial services, provided. All of these products and services result in new financial risks for the bank. These instruments can be both on and off the balance sheet. On-balance-sheet instruments include securities, loans, deposits and borrowings. Off-balance-sheet instruments include loan commitments, standby letters of credit, interest rate swaps, foreign exchange contracts, and interest rate futures and forwards. A bank must have a strategy for profitable risk taking and carefully monitoring, managing, and reporting on these risks. This is neither intuitive nor easy. Banks are faced with the challenge of assigning costs associated with these risks to the appropriate product, organization, and customer segments, while simultaneously isolating responsibility for managing and controlling these risks at the enterprise level.
Transfer pricing methodologies are therefore critical to the understanding of risks and risk management. Although these risks are embedded in different departments within the bank, they must be isolated and transferred to the funding center, often referred to as "Treasury." The cost of these risks should be explicitly charged to organizations, products, and customers through the funds transfer pricing process and centrally accounted for in the interest rate risk unit. Once isolated, strong management review, accounting controls, and ongoing monitoring processes must be in place to control these risks. Transferring these risks to Treasury will centralize the responsibility for managing them.
The FTP system is one of the major interfaces between the commercial side and the financial side of the bank. Any malfunctioning or inconsistency in the system will interfere with commercial and financial management, and will create a gap between global policies and operations of the bank. The application of the proper cost of funds curve is a critical one since it determines how profitability contributions to net interest margin are allocated among cost centers. If the bank sets the transfer pricing curve higher, it will lower the profitability contribution of loans and increase the profitability contribution of deposits.
Adjustments to a base...