The Importance of Risk-adjusted Funds Transfer Pricing
Liquidity and interest rate risk are the primary focuses of a bank treasury/ALM function, and your investment and borrowing portfolios are your largest tools for to manage them. Because most of the typical commercial bank’s liquidity and interest rate risk positions are taken in the loan and deposit books, implementing a risk-adjusted approach when pricing business and measuring outcomes is imperative for best practice risk and performance management.
A transfer pricing system that fails to incorporate the unique interest rate and liquidity risk characteristics of each loan and deposit may unintentionally incentivize excess risk taking, thus creating performance challenges. A sound approach to funds transfer pricing (FTP) will help banks align pricing and operating decisions with their associated risks, thus narrowing the space between risk measurement and risk management.
When FTP is viewed only through the lens of performance management, only half the story is told. Properly adjusting for risk and analyzing the residual between FTP paid and FTP received helps to shed light on the costs associated with the risk mitigating activities of a bank treasury.
When FTP is incorporated into the treasury’s P&L, banks can see how the activities of the core business need to be offset by investing and borrowing transactions.
So how do you achieve that?
The first step is developing an effective FTP system, which will help you better align risk and performance. Incorporating risk information into the systems that incentivize behavior in your business lines will help narrow the gap between simply measuring risks and actively managing them.