Funds Transfer Pricing (FTP)

How to allocate the cost of funds comes up when pricing a trade, approving a new product, or measuring a business line's profitability. A business line that receives the allocation sees the amount in its profitability metrics.

FTP allocates funding costs inside the firm

Funds transfer pricing (FTP) is a process performed by a financial institution's central management function. It allocates the costs and benefits of funding and contingent liquidity risks, as measured at trade inception, to business lines, products, and activities¹. What is allocated is the cost of funding the business and the cost of preparing for liquidity needs under stress (the cost of contingent liquidity). Giving a large benefit to stable funding sources is one example. FTP is an internal pricing of funds. It is different from the transfer price that tax rules set on cross-border transactions within a group.

FTP has two purposes. The first is measuring profitability. FTP is a tool for managing the structure of the balance sheet and measuring risk-adjusted profitability. It influences the volume and terms of new business and the composition of the existing portfolio². The second is dividing responsibility for funding. FTP can transfer funding and contingent liquidity risks to the central function. The central function can then take advantage of natural offsets between business lines, centralized hedging, and a broader view of the whole firm³.

The description of FTP rests on the Basel principles and on the guidance that the Federal Reserve Board, the FDIC, and the OCC issued in March 2016 (the "FTP guidance"). The FTP guidance applies to large financial institutions, such as those with consolidated assets of USD 250 billion or more⁴.

If FTP does not reflect reality, a business line's profitability metrics stop reflecting the risks it takes, and its behavior drifts away from the firm's risk appetite. Examples of what can happen when allocations are inadequate are excessive off-balance sheet commitments and excessive on-balance sheet asset growth⁵. The 2008 financial crisis exposed weak risk management practices for allocating liquidity costs and benefits across business lines⁶. The Basel Committee's 2008 principles likewise called for the costs, benefits, and risks of liquidity to be built into internal pricing, performance measurement, and new product approval for all significant business activities⁷.

How funding costs are allocated

In the FTP guidance's example, the central management function allocates FTP costs to business lines on the basis of the market cost of funding.

Figure description

The market, the central management function, and the business line are arranged from left to right. In the FTP guidance's example, the central management function takes the market cost of funding as its basis and allocates the FTP costs and benefits, measured at trade inception, to the business line's products and trades. Neither arrow is a payment of money. They carry cost information and an internal calculation, so they are shown as dotted lines. The guidance says the allocated results should feed into pricing, business-line metrics, and new product approval.

Putting the FTP guidance's examples in order gives the following steps.

1. The central management function arranges the market cost of funding by term and prepares FTP rates by term (an example is the matched-maturity marginal cost of funding⁸).
2. At trade inception, the central management function selects the point on the FTP curve that matches the trade's holding period, cash flows, interest rate repricing, prepayment, and similar features, and allocates it to the business line (rates should be matched to the trade's features)⁹.
3. The allocated amounts should feed into product pricing, business-line metrics, and new product approval¹⁰.
4. The central management function produces FTP reports, and a senior management group should review them at least quarterly¹¹.

The method is set to fit the firm's size, complexity, business activities, and risk profile, and the example methods are not instructions to use a particular method¹².

The two risks that are allocated

The FTP guidance says that what FTP should allocate is the costs and benefits of the following two risks¹³.

The two use different axes for allocating funding costs. The cost of funding is allocated, for example, according to the length of time an asset is held. The cost of contingent liquidity should be allocated to activities that can create liquidity needs under stress.

In the FTP guidance's example, a 5-year commercial loan is held to maturity and its rate is repriced every 3 months. The interest rate component of funding cost can be set on a 3-month term and the liquidity component on a 5-year term. The FTP cost is the sum of these two components¹⁴.

A hypothetical example of allocating by maturity

Consider a hypothetical example in which Bank M allocates the cost of funds using the term-based FTP rates below (annual), built from its market cost of funding. The calculation is kept simple and does not discount.

For 3 months, the allocation is 1 billion yen × 0.30% × 3/12 = 750,000 yen. For 5 years, it is 1 billion yen × 1.20% × 5 = 60 million yen. At a flat 0.50%, the 3-month allocation is 1 billion yen × 0.50% × 3/12 = 1,250,000 yen, and the 5-year allocation is 1 billion yen × 0.50% × 5 = 25 million yen.

A flat rate allocates 500,000 yen more than the term-based rate to the 3-month trade and 35 million yen less to the 5-year trade. In this example, the 5-year trade uses funds for 5 years, yet a flat rate puts only part of that funding cost into the business line's profitability. The business line with short trades sees its profitability as worse than it really is, and the business line with long trades sees it as better than it really is.

Term-based rates are built on the market cost of funding arranged by term. Funding costs change over time¹⁵. The market funding cost used as the basis for allocation should be derived from reliable, readily available data and should be well understood by the people who use it.

How FTP is used for derivatives

The FTP guidance says the FTP framework should cover derivative activities, in a way that fits their size and complexity. The framework may consider the fair value of current positions, the right to rehypothecate collateral received, and contingent outflows that could occur under stress¹⁶.

Contingent outflows can arise from derivatives through rating downgrades, additional termination events, and market shocks¹⁷. Margin calls are also among the examples of what contingent liquidity risk is allocated to. The funding burden of collateral and margin itself is covered in Funding Variation and Initial Margin.

A trade with a long maturity uses funds for a long time, so it is allocated a long-term funding cost (the example in the previous section). For trading positions, the guidance says allocation, reporting, and data updates should be done more often than for other business, for example daily. Infrequent updates based on month-end balances may miss daily funding and contingent liquidity risks. When a position stays open longer than first expected, the holding period should be reviewed and the FTP costs and benefits reallocated¹⁸.

Deep diveTwo methods used for trading positions

The FTP guidance gives the following two methods as examples of allocating FTP costs to trading positions¹⁹. With either, repo market haircuts may be used to separate the part funded on a secured basis from the part funded on an unsecured basis.

• The weighted average cost of debt (WACD) is the weighted average cost of the debt the firm has issued, mostly expressed as a spread over a benchmark rate. One method applies this rate to the amount of assets expected to be funded on an unsecured basis.
• The marginal cost of funding uses as the FTP cost the appropriate rate at which the firm would borrow additional funds. One method applies the secured borrowing rate to the amount expected to be funded on a secured basis and the unsecured borrowing rate to the unsecured amount.

With either method, the firm should analyze whether risk-taking incentives become misaligned and describe this in the FTP report. For the marginal cost of funding, the firm should also consider comparing current market rates with historical rates.

The contingent liquidity cost of trading positions can be considered through the unencumbered liquid assets held against wider haircuts on trades funded on a secured basis. For derivatives, the cost associated with derivative outflows under stress may also be included²⁰.

Granularity of allocation and internal controls

There are two levels of granularity for allocation, and the firm chooses between them. One is trade by trade, and the other is groups of trades with similar funding and contingent liquidity risk characteristics. Trade-level allocation can be complex and can raise the cost of implementing and maintaining it, but it can measure risk-adjusted profitability more accurately²¹. When allocating to groups, the criteria for forming the groups should be transparent and based on the funding and contingent liquidity risk characteristics.

FTP controls are divided by role, and the guidance says the following should be done²².

The guidance also says there should be ongoing dialogue between the business lines and the central function. This is so that business lines understand the basis for the allocations and the central function understands the funding and contingent liquidity risks of their trades²³.

FTP, FVA, KVA, and transfer pricing

These mechanisms are close in name or purpose, so the table separates them.

FTP is an internal calculation allocated to business lines, while FVA and KVA are adjustments that enter the value of a trade. How KVA is found is covered in Capital Valuation Adjustment (KVA).

The risks covered by FTP are funding and contingent liquidity risks. The cost of capital is not listed, and the guidance only notes that firms may incorporate other risks into their FTP frameworks²⁸.

What this page does not cover

Practices at Japanese financial institutions, the internal procedures of individual firms, and how FTP rates and the FVA funding spread are linked are not covered on this page.

Notes

1. Federal Reserve Board, FDIC, and OCC, "Interagency Guidance on Funds Transfer Pricing Related to Funding and Contingent Liquidity Risks" (March 1, 2016), Background (page 1). It gives the definition of FTP. ↩

2. The same source, Background (page 1). It says FTP is an important tool for managing the balance sheet structure and measuring risk-adjusted profitability, and that it influences the volume and terms of new business and the composition of the existing portfolio. ↩

3. The same source, Background (pages 1–2). It says FTP is also an important tool for centralizing the management of funding and contingent liquidity risks for all exposures, and that the central management function can take advantage of natural offsets, centralized hedging activities, and a broader view of the firm. ↩

4. FTP guidance, footnote 1 on page 1. It defines large financial institutions as banks with consolidated assets of USD 250 billion or more, holding companies with consolidated assets of USD 250 billion or more or foreign exposure of USD 10 billion or more, and foreign banking organizations with combined US assets of USD 250 billion or more. "Such as" in the text is shorthand for this list. ↩

5. The same source, Background (page 2). It says that failing to apply FTP consistently and effectively can misalign business lines' risk-taking incentives with the firm's risk appetite and misallocate financial resources. As examples, it gives excessive off-balance sheet commitments and on-balance sheet asset growth because of mispriced funding and contingent liquidity risks. ↩

6. The same source, Background (page 2). It says the 2008 financial crisis exposed weak risk management practices for allocating liquidity costs and benefits across business lines. It cites the Senior Supervisors Group report (October 21, 2009), noting that several firms acknowledged that with robust FTP practices in place earlier, they would not have carried the significant levels of illiquid assets and off-balance sheet risks that led to sizable losses. ↩

7. Basel Committee on Banking Supervision, "Principles for Sound Liquidity Risk Management and Supervision" (September 2008; the Japanese provisional translation by the Financial Services Agency was used), Principles 4 and 19 (pages 12–13; pages 14–15 of the PDF). Principle 4 calls for internal pricing, performance measurement, and new product approval that incorporate the costs, benefits, and risks of liquidity for all significant business activities. ↩

8. The same source, Attachment (page 6). It gives the matched-maturity marginal cost of funding, based on the firm's term structure of market funding costs, as a common method for non-trading exposures. The principles in the body of the guidance do not prescribe a particular method. ↩

9. The same source, Attachment (page 6). It says FTP rates should match features such as holding period, cash flows, interest rate repricing, prepayment, and expected term as closely as possible. ↩

10. The same source, introduction to the body (page 2) and Principle 4 (pages 4–5). It says FTP costs and benefits should be incorporated into the pricing, business-line metrics, and new product approval of all significant business lines, products, and activities. ↩

11. The same source, Principle 3 (page 4). It says the central management function produces FTP reports, and the senior management group overseeing FTP should review the reports at least quarterly. ↩

12. The same source, Attachment (page 6) and Principle 2 (page 3) of the body. It says the example methods are illustrative and should not be read as instructions to use a particular method, and that the framework should be commensurate with the firm's size, complexity, business activities, and risk profile. ↩

13. The same source, Principle 1 (page 2). It says funding risk and contingent liquidity risk should be allocated. Funding risk includes liquidity and interest rate components, with a higher cost for assets held longer and a larger benefit for stable funding sources. Contingent liquidity risk is the cost of holding unencumbered, highly liquid assets, and the examples given are credit line drawdowns, collateral calls, deposit outflows, and wider haircuts on secured funding. ↩

14. The same source, Attachment (page 6). In the example of a 5-year commercial loan repriced every 3 months and held to maturity, it says the interest rate component can be based on 3 months and the liquidity component on 5 years, and that the total FTP cost is the sum of the two components. ↩

15. The same source, Attachment (page 6). It says funding costs can change over time, so the term structure of market funding costs should be derived from reliable, readily available data and be well understood by the users of FTP. ↩

16. The same source, Principle 2 (page 3). It says the framework should cover derivative activities in a way that fits their size and complexity, and gives as things that may be considered the fair value of current positions, the right to rehypothecate collateral received, and contingent outflows under stress. ↩

17. The same source, Attachment (page 8). It gives rating downgrades, additional termination events, and market shocks or volatility as examples. Collateral calls are an example of contingent liquidity risk in Principle 1 (page 2). ↩

18. The same source, Principle 2 (page 3). It says trading positions should be allocated, reported, and updated more often (for example, daily). It says infrequent updates based on month-end balances may miss daily risks, and that positions that stay open longer than expected should have their holding period reviewed and be reallocated. ↩

19. The same source, Attachment (page 7), Weighted Average Cost of Debt and Marginal Cost of Funding. ↩

20. The same source, Attachment (pages 7–8), Contingent Liquidity Risk. For liquid assets held against wider haircuts, it says that where the haircuts used in FTP differ from those in internal stress tests, the discrepancy should be documented in the report. ↩

21. The same source, Principle 4 (page 5). It says whether to allocate trade by trade or by groups of trades with similar funding and contingent liquidity risk characteristics should be decided by weighing the advantages and disadvantages of both. ↩

22. The same source, Principle 3 (page 4). It says the senior management group should include representatives of the asset-liability committee, finance, business lines, and risk management, among others. ↩

23. The same source, Principle 4 (page 5). It calls for ongoing dialogue between business lines and the central function, so that business lines understand the basis for FTP costs and benefits and the central function understands the funding and contingent liquidity risks of business-line trades. ↩

24. The same source, Principle 3 (page 4). It says reports should be produced at a sufficiently detailed level, such as by business line, product, and activity, so that the senior management group and the central management function can monitor FTP. ↩

25. The same source, Attachment (page 7). It says that where behavioral assumptions such as the likelihood of credit line drawdowns or the stability of deposits differ from the assumptions in internal stress tests, the discrepancy should be documented and included in the FTP report. ↩

26. Yuichi Saito, "金融規制の複合的影響を考慮したXVA" (XVA considering the combined effects of financial regulations), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2017), Section 2 (2) (pages 113–116) (in Japanese). It puts the firm's own funding spread into the FVA coefficient. The scope wording "the positive mark-to-market portion not covered by collateral" follows the explanation on this site's FVA and MVA page. ↩

27. Yuichi Saito, "金融規制の複合的影響を考慮したXVA" (XVA considering the combined effects of financial regulations), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2017), Section 5 (3) (page 130) (in Japanese). It defines KVA as the expected present value of the cost of raising the regulatory capital needed until trade maturity (the cost of capital). ↩

28. FTP guidance, Background (page 1). It says the guidance addresses FTP for funding and contingent liquidity risks, and that firms may incorporate other risks into their FTP frameworks. ↩