Despite a challenging rate environment, changing shape of the yield curve, and intensifying digital competition, bank and credit union finance leaders’ primary role remains unchanged: balancing risk and return to effectively manage the institution’s profit margins.
At the heart of measuring risk and return lies funds transfer pricing (FTP). FTP is a critical tool for accurately measuring a financial institution’s profitability, enabling you to track and analyze net interest margin (NIM) for every segment — such as products, customers/members, officers, and departments — at a financial institution. However, FTP is also important as a risk metric to measure the returns based upon interest rate exposure and to centralize rate and liquidity risk where it can be more efficiently managed.
If you’re considering adopting FTP to better manage your institution’s profit margins, follow these four best practices:
1. Start simple
Don’t get too complex with your FTP calculations too quickly. Starting with a simple methodology can help get the new process off the ground. When beginning to use FTP, aim to make everything as easy as possible. Make it easy to implement and easy to explain to secure buy-in. You’ll want to ensure you can provide value quickly and evangelize early in the process. From there, you can scale up and get more complex and more accurate with the FTP calculations.
2. Integrate with other analytics and tools
Financial institutions have a plethora of data at their fingertips. With FTP, you need detailed, instrument-level data to forecast cash flow. If you have a data warehouse, set up necessary integrations to pull that data from a single source so that your instrument data, like loan and deposit data, live in one place.
After calculating FTP, you can feed those numbers back into your data warehouse, maintaining your organization's single source of truth. Managers who are already accustomed to accessing the data warehouse to understand instrument balances can go to the same place to understand FTP for those instruments. Integrating FTP delivers better analytics and data-driven insights.
3. Identify and isolate FTP components
FTP is comprised of different layers, each of which should be isolated, analyzed, and calculated individually. Start with the market or base rate, then add liquidity premium, optionality, and incentives or other explicit adjustments.
For example, if you have an adjustable loan, but the base rate FTP doesn’t necessarily reflect the total time that the balance will be outstanding, you may want to add a liquidity premium. If that loan is prepaid, you will want to add some additional optionality premium on top of that instrument. And finally, you’ll need to account for any management incentives offered as part of that loan.
4. Review the impact on your organization
To truly understand FTP's impact on your organization, include it in reporting. You should anticipate questions around the results and be prepared to explain FTP’s impact. Integrating FTP with profitability information can help you answer important questions at the product, customer/member, and organizational levels. Which products are profitable that weren’t before? How will the strategy behind customer/member profitability change? Which branches are profitable?
Additionally, FTP can help determine pricing. If you have a loan pricing system, you’ll want to include FTP as part of that calculation — which can change the loan team’s activity — and ensure you work closely with the loan team to foster understanding. The final piece of the impact puzzle is incentives. FTP can help answer the question of whether you’re providing the right incentives on the right products.
Proper FTP measurement and reporting leads to more informed and precise decision-making to maintain and improve profitability. Download our e-book to learn more about the four key elements in measuring and reporting FTP in banks and credit unions.