The Art of Fund Transfer Pricing II

October 17, 2012

Before describing the individual parts that make up the opportunity costs of the fund transfer pricing process, let’s take a look at the concept in general and stress how it ultimately contributes to the bank’s net interest income (NII) and financial statements.

Consider a bank with pure capital market business (no client business) and 100% external refinancing (no equity):


Then we take a look at the EUROBOR yield curves which look like the following:


These are essentially “risk free” interest rates offered and available on the money market and consequently is the underlying opportunity cost for any kind of investment and refinancing for say a EURO denominated bond, i.e. the fund transfer rate. When assigning the rates to the corresponding positions in the balance sheet, we can calculate the banks current Net Interest Income:


Since the market yield curve and consequently the return on the bank’s portfolio are given, the net interest income is easily conceived.


The major question for this bank is whether it can do better by engaging in other types of businesses, such as extending loans or accepting deposits (client business).

In the new balance sheet, the bond was replaced by a loan with equal maturity but with a higher gross interest income. On the other side, the debt obligations were replaced by deposits with the same maturities but lower gross interest expense.


What is now the impact on the bank’s NII?

The bank still has the same return out of transforming maturities from the liability (1 and 2 years) to the asset side (4 years), namely 1.25%. However, on top of that the bank managed to generate a contribution margin of 2% by simply “beating the capital market”, i.e. by earning 1% more on the loan and paying 1% less on the deposits.

The final result shows a NII of 3.25%. By splitting the final NII into the two components, the bank can understand where its profit actually comes from. Besides generating a contribution margin and transforming maturities, there is also the opportunity cost consideration of transforming currencies. This occurs when the loan’s deal currency (DC) does not equal the home currency (HC) of the bank, say when a bank in the U.S issues a loan in Swiss francs.


With this additional split of the transformation margin, there is a clear distinction of the margins that are gained from the transformation of maturities and from the transformation of currencies. At the end, there is no impact on the total NII due to this concept of transformation. So there is still a full reconciliation with the banks financial statements (Accounting):