FTP Profitability Decomposition, RAROC, and Regulatory Links

Book: Financial Risk Management: Applications in Market, Credit, Asset and Liability Management and Firmwide Risk Authors: Jimmy Skoglund & Wei Chen ISBN: 978-1-119-13551-7

The second half of Chapter 7 connects FTP rates to performance measurement and regulation. This is where internal pricing meets capital allocation and P&L reporting.

Economic Value Added (EVA)

EVA = customer rate minus all-in FTP rate (including credit, capital, liquidity, and option spreads).

Positive EVA means the product is expected to contribute to profitability ex-ante. But EVA is an expectation, not a guarantee. Ex-post results can diverge, especially for credit risk on small pools.

Risk-adjusted return on capital (RAROC)

Two products with the same EVA are not equal if one uses twice the capital. RAROC = EVA / allocated capital.

Banks set RAROC hurdles tied to shareholder return targets. New assets must clear the hurdle. This prevents growth in low-margin, high-capital business.

The chapter walks through a credit-risky mortgage example: customer rate 5.5%, all-in FTP about 4.93%, EVA about 57 basis points, RAROC about 5.7.

Profitability decomposition

With synthetic FTP instruments, total bank P&L splits into:

• Branch net interest margin (customer leg vs synthetic FTP)
• Treasury residual (synthetic FTP vs actual funding)

Equation 7.1 in the book: Portfolio = (Asset minus Synthetic FTP) + (Synthetic FTP minus Actual Funding).

Branches become standalone performance units. Treasury owns the funding mismatch and rate risk on the residual book.

Economic fair value

FTP rates also discount uncertain non-traded cash flows for economic value (solvency) analysis. The same spreads used for margin measurement feed long-term balance sheet valuation at the loan level.

This breaks the old limitation where economic value was only computed at the aggregate balance sheet level.

Holistic customer view

A customer can be profitable overall even if some accounts have negative EVA. Cross-subsidization is a business choice, not a modeling error. But you need FTP to see it clearly.

Risk-based FTP measures fair value performance, not accounting P&L. A product can show positive accounting margin but negative economic value once capital and liquidity costs are in.

Regulatory connections

Regulators care about FTP because it drives product pricing and risk-taking incentives. Basel and EBA guidance on liquidity risk pricing ties directly to FTP implementation.

ICAAP and stress testing use profitability projections that depend on FTP assumptions. If FTP understates liquidity cost, stress test earnings look too rosy.

Pillar 3 disclosure and internal capital adequacy assessment all assume the bank knows which businesses consume capital and liquidity. FTP is the allocation mechanism.

Scope limits

FTP works well for banking book items with clear cash flows. Trading book and complex structured products need different frameworks. The chapter is explicit about scope.

Solvency decomposition

FTP also breaks economic value (long-term solvency) to position level. Discount uncertain cash flows at all-in FTP rates and you see which loans destroy balance sheet value even when current-year P&L looks fine. This is the bridge between ALM and strategic portfolio pruning.

Pillar 2 and profitability reporting

Supervisors use profitability analysis to judge whether risk-taking is rewarded correctly. Mispriced FTP can hide build-up of low-margin, high-risk assets that pass accounting tests until credit cycle turns. ICAAP narratives often reference FTP-based EVA and RAROC rankings as evidence of sound incentives.

Scope and limits

FTP is strongest for banking book cash flow products. Trading desks, private banking with fee income, and cross-subsidized product bundles need overlays. The chapter warns against forcing every business line into one FTP template without understanding cross-sell economics.

My take

RAROC is the decision metric that survives board meetings. EVA tells you if the spread is positive. RAROC tells you if it is worth the capital.

If your bank still prices deposits at zero internal cost in 2026, the liquidity chapter of this book explains why that is a problem and this chapter explains how to fix it.

Ex-ante fair value is not ex-post profit. A mortgage with positive EVA can still default. FTP sets expected performance. Credit monitoring handles realizations. Confusing the two leads to blaming FTP when the problem was underwriting.

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