Yep, the 90s. It was all the rage and I jumped on board like a millennial on the Grateful Dead Fare Thee Well scene – I’m not sure what it’s all about, but I want to say I was there.
I’ve got my P&L, what else do I need? This is often the response from bankers who are offered the opportunity to invest in a profitability system. So, then, what is the allure of purchasing, implementing, and maintaining these systems? I’m not writing this to persuade or dissuade the reader from exploring the profitability rabbit-hole. In fact, at one time I was doing a great deal of persuading, and now, well, let’s just say I’m reformed. So, for a long time I’ve felt the need to get the subject out of my head and on paper (time caught up with me, so now it’s a blog series). And since bankers live and…well, let’s stay positive – live by the margin, I’m going to focus this series for now on the margin measurement component of a profitability system: the FTP, or funds transfer pricing system.
Funds Transfer Pricing (FTP) is the banker’s Robin Hood: it takes from the lenders and gives to the deposit gatherers in an attempt to figure out where value is being created in the bank. If all you have is the P&L, all you have is the big picture – no details – is the premise. Sitting in the middle is the sheriff, deciding how much to take from the loan income and how much to give to the deposit gatherer for finding cheap money. Typically there is a mismatch or gap and the difference ends up in the sheriff’s pocket (not unlike how it gets done in Illinois.)
Consider Figure 1 above. The loan rate is above the risk-free yield curve because the bank has taken on risk (credit, liquidity, etc.) If the loan rate were below the curve, the bank would be better off buying a treasury note. Deposits are the opposite. They’ve borrowed below the risk free rate. Had they paid more than the treasury, it’s likely they would have been better off borrowing, assuming they had access. The amount kept by the funding center, the gap, represents the income earned by taking on interest rate risk.
Now let’s take a look with some numbers. Figure 2 illustrates a simple situation where the loans are earning 5% and deposits are paying .4%. The net real bank spread is 4.60%. But how much of that 4.60% was really contributed by the lenders? We are going to charge them for use of the funds using one or more of a variety of methods. We’ll get to methods later, but let’s assume we charge them 2.32% (we found this on the yield curve above at the 10 year CMT point). Their net spread is 2.68%. Then we have to credit the deposits for bringing in dollars to lend out; assume we credit them .67% (the 2 year rate). Their net interest income is .27%. So the lenders contribute 2.68% and the deposits .27%, but that adds up to 2.95% - where did the other 1.65% go? To the treasury manager (funding center). This 1.65%, if viewed in an IRR system, would represent the income generated by taking on mismatch risk, assuming the transfer rates to the units are the risk free (treasury) curve. Why did loans and deposits get different rates? Because the rate was picked off of a sloping yield curve and the term of the deposits is less than that of the loans.
This only works if the FTP is somehow assigned using fair rules and real market rates. Otherwise, you can game the system to make branches, products, and other measurable business units look as profitable or unprofitable as you like. This leads us to the next discussion – methods for choosing the FTP rate – How should the FTP rate be assigned? Well, in a number of ways from the simple to the complex and I will address each of the methods in the next post. For now, start to contemplate whether this makes sense and if it is fair.