What Is Fund Transfer Pricing and How Does It Work?

Fund Transfer Pricing, or FTP, is an internal accounting framework financial institutions use to manage profitability and risk. It functions by creating an internal price for money, allowing a bank to measure the performance of its various operations on a standalone basis. The system assigns a cost of funds to departments that use money, like lending divisions, and provides a credit for funds to departments that bring money in, such as those focused on deposits. This process is a management tool that provides clarity on where value is created and is not for external financial reporting.

The core function of FTP is to determine the profit contribution of different business units. By establishing a standardized internal cost for money, an institution can analyze the profitability of specific products and business lines with greater accuracy. This internal pricing separates the results of customer-facing activities from the financial consequences of the bank’s broader funding and interest rate management strategies.

Core Objectives of Fund Transfer Pricing

A primary objective of a fund transfer pricing system is to enable precise performance measurement. FTP isolates the profitability of individual business units by assigning a standard cost or credit for funds, which removes the effect of fluctuating market interest rates from their direct results. For example, a commercial lending team’s performance can be judged based on the spread it earns over the transfer price. This separates its ability to price for credit risk from the deposit team’s ability to gather low-cost funding.

This separation of performance allows for a more accurate evaluation of net interest margin at a granular level. Without such a system, a loan’s profitability would be tied to the bank’s overall cost of funds, which can obscure the true performance of the lending decision. By providing a stable benchmark, FTP allows for consistent performance tracking over time and across different business units.

The framework is also a tool for centralizing and managing risk. Individual business lines, through their normal activities of making loans and taking deposits, create interest rate and liquidity risks. A branch that makes a 30-year fixed-rate mortgage, for instance, creates interest rate risk for the bank. An FTP system transfers this risk from the branch to a central function, the Treasury department, by having the branch “sell” the funding risk to Treasury at a matched transfer price.

This centralization allows for the aggregation of all such risks from across the institution. Instead of having pockets of unmanaged risk in various business units, the Treasury department can view the bank’s entire interest rate and liquidity risk profile. This consolidated position can then be managed strategically at an enterprise level, using financial instruments and funding strategies impractical to implement at the business unit level.

The transfer price itself creates behavioral incentives for business unit managers. The rates published by the FTP system directly influence the types of assets and liabilities that business lines are encouraged to pursue. If the transfer price for long-term funding is high, it signals to loan officers that they must originate long-term loans with high customer rates to be profitable, discouraging assets that are not priced appropriately for their risk.

Conversely, the system can incentivize the gathering of stable, low-cost sources of funding. By offering a higher internal credit rate for long-term, stable deposits compared to short-term ones, the FTP system encourages branches to focus on building a stable funding base. This aligns the incentives of the business units with the overall risk management and profitability goals of the institution.

Key Components of the Transfer Price

The transfer price applied to a loan or deposit is built from several components. The foundational element is the Base Rate, derived from a market-based interest rate curve representing the cost of money at various maturities. The standard benchmark for this curve is the Secured Overnight Financing Rate (SOFR), which has replaced the London Inter-bank Offered Rate (LIBOR).

SOFR is based on transactions secured by U.S. Treasuries, making it a nearly risk-free rate. To account for this, institutions add a credit spread adjustment to the SOFR curve to reflect their own unsecured cost of funds. By using this adjusted, market-based curve, the bank transfers its core interest rate risk from the business units to the Treasury department. The Base Rate for a five-year loan would be the five-year point on this curve.

Building upon the Base Rate is the Liquidity Premium. This addition compensates the institution for the cost and risk associated with funding an asset over its entire life. Longer-term assets are less liquid and create more funding risk than short-term assets. The Liquidity Premium quantifies this risk, assigning a higher charge to assets that are more difficult to fund.

The calculation of this premium is specific to each institution and is based on its own funding costs in the capital markets. For instance, the premium for a five-year maturity might be derived from the spread the bank pays on its own five-year bonds over the Base Rate. This ensures the price charged to a loan reflects the bank’s actual cost of raising five-year funds.

The transfer price may include other adjustments to reflect additional risks. A notable example is a charge for contingent liquidity risk. This applies to products like committed lines of credit, where the bank must be prepared to provide funding on demand. The FTP system can add a specific charge to these commitments to cover the cost of maintaining the necessary standby liquidity.

Common Fund Transfer Pricing Methodologies

Financial institutions apply the components of the transfer price using several methodologies, which vary in complexity and precision. The most basic approach is the Single Pool Method. In this model, the institution calculates a single, blended cost of funds by averaging the interest expense on all of its liabilities. This one rate is then used as the transfer price for all assets, regardless of their individual characteristics.

While simple to implement, the Single Pool Method has significant drawbacks. It creates a cross-subsidy where short-term assets are overcharged for funding and long-term assets are undercharged. This practice distorts profitability signals and can lead to poor risk-taking decisions, so this method is rarely used by sophisticated institutions.

A more refined approach is the Multiple Pool Method. This methodology improves upon the single pool concept by creating several cost pools based on broad maturity or repricing buckets. For example, the bank might establish separate pools for short-term funds, medium-term funds, and long-term funds. Each pool has its own average cost, and an asset is assigned a transfer price based on the pool that corresponds to its maturity.

This method provides a more accurate allocation of funding costs than the single pool approach because it begins to match the tenor of assets with corresponding funding costs. However, it is still an approximation, as all assets within a wide bucket, such as a 10-year loan and a 25-year loan in a “long-term” pool, would still receive the same transfer price.

The most widely accepted methodology is Matched-Maturity FTP. Under this model, each asset and liability is assigned a unique transfer price based on its specific maturity, repricing frequency, and other cash flow characteristics. A 30-year fixed-rate mortgage is assigned a 30-year transfer price, and a five-year auto loan receives a five-year price, all derived from the institution’s detailed FTP curve. This approach eliminates the cross-subsidies inherent in pool-based methods and provides the most accurate basis for performance measurement and risk management.

The Role of the Treasury Department

The entire fund transfer pricing framework is managed by the institution’s Treasury department, sometimes known as the Asset Liability Management (ALM) group. This department is responsible for creating, maintaining, and publishing the official transfer pricing rates for the organization. They develop the underlying curves, determine the appropriate liquidity premiums, and ensure the system is applied consistently.

Treasury functions as the institution’s “internal bank.” It “buys” all funds from the liability-gathering units, such as retail branches, at the designated transfer credit rate. It then “sells” these funds to the asset-generating units, like the lending divisions, at the corresponding transfer charge rate.

A primary function of the Treasury department within this framework is to manage the residual risk. After the FTP system has transferred interest rate and liquidity risks from the business units, these risks are aggregated and centralized onto the Treasury department’s balance sheet.

Treasury’s resulting profit and loss statement reflects the net outcome of these centralized risks. For example, if Treasury is “buying” short-term funds from depositors and “selling” long-term funds to mortgage lenders, it is left with an interest rate risk mismatch. It is Treasury’s job to actively manage this consolidated risk profile for the institution, using tools like interest rate swaps or issuing long-term debt.