Fund Transfer Pricing Essay Example | Topics and Well Written Essays - 500 words - 1

Fund Transfer Pricing - Essay Example It is evidently clear from the discussion that commercial banks have two divisions: deposit and lending. The deposit segment accumulates funds from customers. These funds are lent to other customers as loans through the lending division. The interest that banks earn on loans is interest income while interest on deposits is interest expense. The difference between interest income and interest expense is net interest income and is reported on the income statement. It is not a guarantee that all loans are profitable neither do all deposits cause losses. Different deposits have varying values as sources of loans and in the same way, different loans have a varying cost of funding. The main purpose of finance transfer pricing is to measure independently how different sources of funding contribute towards the profitability of banks. Assume a two-year loan financed by a three-month deposit. Assume also that the deposit segment acquires $1,000,000 worth of funds from the customer at a cost of 4%. These funds are passed to the treasury at a funds transfer-pricing rate. Assuming that the rate is 6%, the bank would earn a deposit spread of 2%. The treasury would then pass the funds to the loans department at a funds transfer-pricing rate of 8%. The loans department would then extend the loan to customers at an interest rate of 11%, earning a deposit spread of 3%. On the other side, the treasury would earn a 2% spread for managing the interest rate risk that arises from the mismatch in the maturity of funds. Assigning the funds transfer rate for treasury, the loans and the deposit divisions of the bank decomposes the spread earnings across the three divisions as illustrated in the paper.