Funds Transfer Pricing Basics for Banking Book Profitability
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
Chapter 7 is about internal prices. Funds transfer pricing (FTP) assigns a funding cost to every loan, deposit, and line on the balance sheet so branches and treasury can see who is actually profitable.
The shadow balance sheet
FTP creates synthetic funding for every real asset and synthetic earnings assets for every real liability. Each branch gets a matched book. Treasury holds the residual.
A loan gets a synthetic liability at the matched-maturity funding rate. The branch earns the spread between the customer rate and the FTP rate. Treasury manages the gap between synthetic instruments and actual funding.
This is effectively an interest rate swap between the branch and treasury at zero upfront cost.
Why FTP matters
Two traditional goals:
- Centralize interest rate risk in treasury so branches focus on customer business
- Measure ex-ante performance of loans, deposits, and other banking book items
Without FTP, a branch that writes long-term fixed-rate loans funded by short-term deposits looks profitable until rates move. FTP strips out the rate risk and shows the real margin.
Matched maturity concept
The basic FTP rate is the interbank funding cost for the asset’s maturity. A 5-year bullet loan gets a 5-year funding rate, even if the bank actually funds with overnight deposits.
A fixed-term deposit gets a FTP earning rate at matched maturity. The branch margin is deposit rate minus FTP rate (usually positive because deposits are cheap).
Risk-based FTP
Interest rate risk is just the start. Banking products carry credit risk, liquidity risk, embedded options, and capital costs. A proper FTP program includes all of them:
- Credit spread: expected loss reserve or hedge cost
- Capital charge: cost of equity allocated to the product
- Optionality: prepayment, withdrawal, and cap/floor costs
- Liquidity premium: mismatch cost plus contingency buffer cost
Basel III requires banks to include liquidity costs and benefits in product pricing. CEBS guidelines push the same in Europe.
Liquidity pricing splits into mismatch funding cost and contingency buffer cost (the opportunity cost of holding HQLA). A cheap liquidity hedging program means lower FTP liquidity add-ons and more competitive loan pricing.
Embedded options
Deposits are withdrawal options. Mortgages have prepayment risk. If FTP ignores these, branches get rewarded for selling products with hidden optionality. Caps and floors on loans look like better deals to customers but carry real cost.
Credit risk centralization tradeoff
Clearing credit risk to treasury via FTP spreads makes sense for portfolio hedging. But it can remove branch incentive to underwrite carefully. The book flags this tension explicitly.
Multi-period and uncertain cash flows
Most real products have uncertain maturity. Demand deposits have no fixed term. Mortgages prepay. FTP for these products uses behavioral maturity profiles or option-adjusted spread models. The matched-maturity rate applies to the expected cash flow tenor, not the legal maturity.
Getting this wrong subsidizes short funding for long assets. That is the classic ALM trap FTP is meant to expose.
Capital and liquidity add-ons in one rate
The all-in FTP rate is a stack: base funding curve + credit spread + liquidity premium + capital charge + option cost + business markup. Each component maps to a risk function elsewhere in the bank. When regulators ask if liquidity risk is in product pricing, they mean this stack includes a liquidity line item, not a footnote.
My take
FTP is how banks implement transfer pricing economics inside the firm. Done well, it aligns incentives. Done poorly, it subsidizes bad business lines that look profitable because risks are not priced in.
The Basel III push to include liquidity in FTP connects Chapters 6 and 7 directly. Liquidity risk measurement is not academic if it flows into the price of every loan.
Skoglund (2013), cited throughout the chapter, treats FTP as the internal market that clears risk between business units and treasury. That framing helps when branches complain FTP is “taxation.” It is the price of the risks treasury absorbs centrally.
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