Funds Transfer Pricing (FTP) evolved in the 1980s to help financial institutions effectively manage interest rate risk (IRR) and allocate income and expense within the firm. It gained further focus after the 2007–2008 financial crisis in supporting management of liquidity risk. For most firms today, FTP includes both IRR and liquidity risk cost benefit allocation. It affects the pricing of assets and liabilities based on the unique structure of the transaction. FTP enables firms to allocate and measure income, expense, and profitability of business lines, as well as allow the central Treasury to provide relevant IRR and liquidity risk-based incentives on behalf of the firm as a whole.
Since FTP relates to many levels of the organization and has impacts across business lines and legal entities, a principle-based approach is crucial to help ensure there is clarity in understanding and consistent operation of the process. As a result, firms often rely on a set of building blocks that enforce the principles in order to construct an effective governing policy and operating framework. Building blocks often include:
— Principles and organizational structure – The principles themselves are the starting point. Firms often develop these—varying the number based on their needs—to outline the fundamental elements of the process and help ensure transparency and clarity of communications and relationships between executive management, business lines, Treasury, and risk oversight. Since FTP involves setting incentives and attributing costs and benefits to business units, it is critical that the established principles are supported at all levels of the organization.
— Cash flow model usage – To assign relevant business unit allocations of income and expense, cash flow models for all on/off-balance-sheet positions are crucial. Cash flows are typically created using the same modeling approaches and assumptions that apply to interest rate and liquidity risk measurement. Usage of consistent cash flow models and assumptions for both risk measurement and FTP calculation can avoid inconsistent risk measurement outcomes and differing or conflicting risk management actions.
— FTP curve setting – Firms construct curves to assign costs and evaluate cash flows from interest rate and liquidity funding risk. Interest rate costs are often driven by markets directly while liquidity funding costs (e.g., potential funding spread changes) are often based on the firm’s business structure.
— Liquidity reserves – It is important for firms to assess and manage liquidity contingent risk or the inability of a firm to meet its payment obligations. This form of liquidity risk is assessed based on a firm’s liquidity stress tests and the results are allocated based on the stress test drivers, thereby incorporating the costs in the FTP measurement process.
— Internal bank profit and loss – These building blocks are used to assess business results for on/off-balance sheet transactions, providing the firm with the ability to allocate, analyze, and understand profit and loss contributions of businesses, products, or even transactions.
— FTP application – A successful FTP process requires a developed Information Technology (IT) infrastructure and data process to provide ongoing and ad hoc reports and analysis that is granular and sufficiently detailed to understand business line income and expense contributions. Infrastructure also includes FTP pretransaction and tear-up communication processes for business lines.