Banks have a lot of different business units, and management would like to be able to evaluate each business unit as an independent profit center. This would allow the bank, for example, to compare the performance of its residential mortgage unit to its credit card unit.
But there’s a problem.
The bank’s treasury department manages the liability side of the balance sheet and therefore incurs interest expense, while the bank’s business units make loans that generate interest income.
Thus, how do you evaluate the profit of the treasury department if it has no interest income? And how do you evaluate the profit of a business unit (e.g., commercial lending) if that unit incurs no interest expense?
This is where funds transfer pricing comes into play.
Funds transfer pricing is the process of allocating the cost of funds (interest expense) to business units and allocating interest income (from loans, credit cards, etc.) to the treasury department.
This permits each business unit to be treated as an independent profit center.
To determine the cost of funds for different business units, the treasury department would create a cost of funds curve (FTP curve) that represents the current costs of raising funds. A higher cost of funds would be assigned to business units that have riskier products.
Funds transfer pricing is thus a mechanism for allocating interest income and expense so that each business unit can be evaluated for its net interest margin.
The allocation of interest expense and interest income to business units is purely for internal use and performance evaluation; it doesn’t affect the financial statements reported to investors.
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