Understanding how individual customers, products, channels and departments contribute to profitability is imperative to managing a proactive bank. The first step in accurately measuring profitability is calculating funds transfer pricing.
Funds transfer pricing is the most important component in understanding profitability, because it allocates the net interest margin to each account on an institution’s balance sheet.
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When banks understand which accounts are truly contributing to their net interest margin, they then can manage them more effectively and gain more accuracy in their profitability results.
While many community banks focus on calculating a precise funds-transfer-pricing rate, some fall short in their potential analyses. Attaining deeper insight into a bank’s funds-transfer-pricing rate is essential to making better pricing decisions and understanding its overall performance.
Three different types of analysis will provide deeper insight into your community bank’s funds-transfer-pricing calculations and will help improve pricing decisions throughout the organization. They will help your bank understand not only its current pricing decisions but also whether that pricing is in line with its corporate goals and strategies.
1. Plot margin against credit score. Funds-transfer-pricing reports typically include balances, rates, funds-transfer-pricing rates and funds-transfer-pricing spread for the bank’s portfolio. By simply adding the relevant credit score to each customer record, banks can determine whether their loan officers are implementing risk-based pricing. One would assume that a bank would have a higher funds-transfer-pricing spread for loans with a lower credit score, but this is not always the case.
If the distinction between higher- and lower-credit-quality loans is not measureable, then a bank may want to consider reevaluating its pricing methods to establish a stronger correlation between pricing and risk. Banks may not even realize that they need to enforce stricter guidelines when it comes to pricing lower-quality credits, and plotting margin against credit score helps them gain this level of insight.
2. Evaluate loan originations by officer. Although understanding the overall contribution of a bank’s portfolio is certainly valuable, an incremental analysis that reveals loan originations by officer helps focus on more recent, relevant activity. Banks should focus on what’s happening now rather than a sum of all historical lending decisions, because current activity is more actionable and helps correct course if necessary.
Drilling down into each individual loan officer’s portfolio also helps banks develop a more effective incentive compensation plan. Often an incentive compensation plan is not rightly aligned with a bank’s processes for measuring contribution. Segmentation by loan officer helps management lead loan officers in a way that positively contributes to profitability and overall performance.
3. Consider the time dimension. Although evaluating current pricing is extremely important, gaining insight into the historical and future trends in funds-transfer-pricing results can be equally important. Banks should consider the following three time frames when analyzing funds transfer pricing for their total portfolios:
Current performance represents the present time period. Banks can leverage this time dimension, for example, to quickly rank which loan officers (or products or centers) have originated the most volume within the defined time period. By also ranking the funds-transfer-pricing spread that has been booked for those volumes, management can gain insight into the pricing decisions those officers have made and if, for example, they may be compromising profit for volume.
Historical performance represents historical snapshots of previous period results. Banks can compare an officer’s historical pricing trend by product to the bank’s overall funds-transfer-pricing spread for the same product for any designated period. This information will help establish trends of how products have been historically priced, enabling management to determine whether underperforming pricing trends are an irregularity or an ongoing problem.
Prospective performance represents the future period’s runoff of the current portfolio for any product and any loan officer. This helps banks understand the impact of maturing spread on portfolio performance. Banks also can better determine new volumes and rates needed to meet their targets when planning budgets.
Each of these time dimensions pinpoint pricing opportunities within an institution, but as a group they provide management and each loan officer a perspective of overall pricing performance and insight into where improvements may be needed.
Often banks that have implemented funds transfer pricing have ignored a great deal of analytical richness. They focus on accuracy, but fail to deliver analytically rich reports that are actionable and can assist in the decisions that help shape profitability. Diving deeper into funds-transfer-pricing results can completely change the understanding of the makeup of a bank’s net interest margin and how its activities have contributed to it.
To prosper in today’s uncertain economic environment, a solid funds-transfer-pricing foundation is necessary to create a clear understanding of the risk-adjusted contribution of customers, channels, products, loan officers and the like.