Basic Concepts and Components of Funds Transfer Pricing (FTP)

Understanding the Bank as Both a Borrower and Lender

At its heart, a bank functions as an intermediary, borrowing money from one group and lending it to another. The price at which a bank borrows money, usually through deposits or other liabilities, and the price at which it lends out, typically through loans or other assets, creates the fundamental dynamic of banking profitability.

Concept of the "Internal Market" for Funds within a Bank

Within a bank, there exists a conceptual "internal market" where various business units interact, 'borrowing' and 'lending' funds to each other. FTP acts as the internal pricing mechanism for these transactions. By setting an internal price for funds, FTP ensures that each unit bears a fair share of the bank's overall funding cost and earns a just portion of its overall return.

Key Components of FTP

1. Core Deposits:

   • These are the deposits that a bank's customers keep in their accounts for regular transactional purposes, such as checking or savings accounts. They are relatively stable and provide a cheap source of funds for the bank.

2. Loans:

   • These are assets for the bank, where it lends out money expecting a return in the form of interest. The interest rate charged on loans often varies depending on the risk and maturity of the loan.

3. Wholesale Funding:

   • Besides core deposits, banks often borrow from the interbank market or issue bonds to raise funds. This source of funding is usually more expensive than core deposits and may be used to manage liquidity or fund long-term projects.

4. Capital:

   • Equity capital and retained earnings act as a buffer for the bank, absorbing losses and ensuring solvency. While capital doesn't incur interest costs like borrowed funds, it does have a cost in terms of expected return by shareholders.

The FTP Rate

Central to FTP is the rate at which funds are transferred internally, known as the FTP rate. This rate reflects the bank's overall funding cost and is determined by various factors, including external market interest rates, the bank's risk profile, and the maturity of the funds. The goal is to set this rate so that when applied to both assets (like loans) and liabilities (like deposits), it accurately reflects the true profitability of each business unit.

In conclusion, the basic components and concepts of FTP revolve around understanding the bank's dual role as a borrower and lender and using this understanding to price the internal transfer of funds. By doing so, banks can achieve a more granulated view of profitability and ensure that each business unit's performance is evaluated in alignment with its contribution to the bank's overall financial health.