Funds Transfer Pricing:Cracking the Code onDeposit ValuationBY STEVE TURNER

unds transfer pricing (FTP) is a

critical tool in managing bank

balance sheet composition, widely used

to evaluate and optimize business line

profitability and neutralize business

line interest rate risk.

While FTP has been little changed at manyinstitutions for years, questions about its applicationsand underlying methodologies have suddenly becomefront burner issues. Competitive deposit pricing, forexample, often is viewed as “irrational” by FTPtraditionalists who have not yet integrated factors suchas customer behavior, balance sheet structure, andmarket prices for options and liquidity into theirmeasurements.

Importantly, unrefined FTP methodologies have ledmany banks to severely understate the value of long-liveddeposit accounts. Debates on the value of deposits havestrained relations between the treasury and deposit-taking business units as they strugglewith antiquated tools to validateresponses to aggressive competitoractions. The result: stalling depositbalance growth at the precise time

when these banks are staggering under the weight oflarge loan portfolios while stranded from wholesalefunding markets.

To break out of this trap, progressive bankers arerevising FTP to integrate balance sheet structural viewsinto deposit pricing decisions, providing a muchsounder basis for competitive pricing strategies. Forexample, some of these bankers are expanding theirunderstanding of the money market deposit accountportfolio through refined identification and behavioralanalysis of MMDA customer segments. These samebankers also are developing multiple-path analyses ofpromotional certificates of deposit to reflect segmentdifferences in how these CDs roll over.

Instead of revisiting FTP as a one-time crisis response,some banks have decided that the current heightened levelof competitiveness in deposits (and, with a return tostable markets, loans) is here to stay, and they haveupgraded their approaches to consistently generate theexpanded and more precise information needed to makebetter long-term decisions. These progressive banks areapplying refined FTP valuations in pricing, planning, andperformance measurement. Analytical enhancements

include measurements of the overallbalance sheet liquidity position and ascientific understanding of likelycustomer behavior in various market andeconomic scenarios.

To get back on track in a radically changed deposit market, progressivebanks are using a three-step process to rethink funds transfer pricing.

F

BREWING PROBLEMS WITH FTPExtensively used for years within major banks, FTPseeks to illuminate the individual product profitabilityof loans and deposits by matching them with anunbiased wholesale market interest rate curve, mostoften the Libor/interest rate swap curve, to eliminate thebenefits or costs of interest rate mismatches. The spreadthat remains, setting aside other risk issues, is theinherent value of these loans and deposits to the bank.

The accuracy of these measurements is complicatedby customer behavior that affects withdrawals andprepayments in response to interest rate movementsand liquidity stress events. Only recently have tools formeasuring deposit behavior matched the precisionavailable to treasury for measuring and managingmarket risks.

For example, many banks continue to labor underapproaches that have been largely static for many years— in some cases decades. Often, historical patterns ofbalance sheet responsiveness to significant interest ratechanges for MMDA and similar accounts are used todeduce the “fixed” and “floating” proportions of thedeposit base. In turn, the designated fixed and floatingportions are matched with respective long- and short-term market indexes to form a blended rate for thewhole portfolio.

This basic framework is appropriate. Yet itsusefulness often is limited by static, unrealisticallysymmetric and under-informed price elasticity metrics;insufficient granularity within product lines; andexcluded evaluations of the liquidity benefit of loyalbalances. In such circumstances, FTP applications areplagued by reliance on simplistic assumptions; limitedrelevance with specific customer groups, products andmarkets; potential unintended sales and marketingbehaviors driven by FTP-induced performanceincentives; and a heightened potential for reversals whenactual results collide with isolated mathematical models.

These shortcomings point to four major types ofFTP management challenges.

First is the challenge of management inaction,typically resulting from the oft-held perception thatthe institution can get by without investing inadvanced FTP methodologies, and skip the effort andexpense of refinements. While such attitudes perhapswere tolerable in prior healthy markets, they now arecompromising important decisions on pricing andresource allocation. Indeed, FTP shortcuts havebecome outright handicaps in the struggle to cope withcurrent market upheavals; to keep pace with

competitors skilled in applying advanced measures;and to address balance sheet structural concerns,particularly in consumer deposit strategies.

Second, in many instances, FTP analyses have notbeen sufficiently granular to calibrate — and adequatelyanticipate — loan and deposit repricing and attritionbehavior in varying interest rate and stressed liquidityenvironments. To be fair, the data and tools for gainingdeep insight into customer behavior have evolvedrapidly in recent years, allowing for measurementprecision that was heretofore not possible.

Third, balance sheet structural positions have notbeen effectively incorporated into FTP valuations.That is, all else equal, a bank with a loan-to-depositratio of 0.70 should value liquidity differently than abank with a 1.20 loan-to-deposit ratio.

While almost all banks have some form of liquiditymeasurement and contingency liquidity plans, manydo not pursue liquidity measurement and managementwith the same commitment that is demonstrated intheir capital management. The result is a gaping holein their application of FTP, with little differentiation ofFTP based on an advanced internal understanding ofthe bank’s unique liquidity position. With a structuralunderstanding of the balance sheet in hand, a bankneeding liquidity can better quantify the rationale forpremium rates on deposits. Conversely, banks withexcess liquidity can better justify a more aggressiveposture in the lending markets.

Fourth, silo coordination issues often becomeevident when an integrated approach is precluded bycommunication and organizational impediments. Inthese situations, the financial market acumen oftreasury and the customer behavioral knowledge in thebusiness lines are not effectively brought together. Bycontrast, highly-advanced risk practitioners havelearned to break down institutional walls, permittingthe formulation of integrated responses to risk/returnissues and opportunities.

GETTING ON TRACKAlthough competition for deposits is ferocious in thecurrent market, progressive bank treasury officers quiterightfully want to approach deposit valuation from theinstitution’s own center of gravity and not from apurely external perspective. Along with establishing abase market interest rate curve, leaders thoroughlyassess the bank’s liquidity position and incorporatecustomer price elasticity insights as well. The resultingcomposite picture builds a better foundation for all-

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important decisions about market pricing, resourceallocation and balance sheet positioning.

There are three major steps in improving FTP(with a particular emphasis on its applicability todeposit pricing):

1) Balance sheet risk review — To anticipateemerging liquidity requirements, leaderscomprehensively review the flow of deposits,borrowings, loans and investments, andevaluate how the aggregate funding positionstacks up against bank targets, particularly in ahypothetical situation of a moderately stressedenvironment. This information is combinedwith other aspects of the bank’s liquidityposition, including the overall riskiness ofthe bank relative to its target risk rating, todevelop a composite liquidity profile thatquantifies liquidity to levels of specificitynot previously considered worthwhile. Thisincreases the value of knowing how fundinginstruments, particularly deposits, likely willbehave in stressed environments.

2) Behavioral modeling — To improve theirunderstanding of the rate-driven circumstancesin which customers are most likely to eitherextend or terminate various types of depositaccounts, leaders are incorporating precisecalculations of price elasticity of demand. Thispermits a far more accurate discernment ofdurable vs. volatile balances, and the likelyimpact of various rate positions in changingmarket scenarios. Leaders also are overlayingnew insights on how accounts will behavein stressed environments, often leading togreater differentiation of internal valuations ofconsumer and commercial deposits (and theliquidity benefit they confer).

3) Valuation refinement — Equipped with theresults from steps one and two, leaders aredeveloping a new generation of precision FTPmodels that put a much finer value to therepricing, liquidity, and elasticity characteristicsof loans and deposits. This information isused as critical decision support for pricingmodels, planning, business line performancemeasurement, and long-term resource allocation.

CALL TO ACTIONFrom a larger perspective, these FTP initiatives arepart of a pricing revolution in retail, small business,

and commercial banking. Along with evaluatinginternal requirements and market and competitivefactors, leading banks are systematically evaluatingcustomer behavior, as expressed in price elasticity ofdemand. Such quantitative insights then become thebasis for greater management integration betweentreasury and retail.

A recent study by Novantas highlights one of thegreat uncertainties in FTP methodology, which is howto place a value on long-lived deposit accounts. Forexample, how should the bank evaluate and valuemoney market deposit account balances that areexpected to stay with the institution in most rateenvironments? Or certificates of deposit that areroutinely rolled over, effectively transforming, say, aone-year CD into a five-year liquidity instrument?

Each bank would reasonably be expected to answerthese questions somewhat differently based on theunderstanding of their customers’ behavior; thecompetitive environment; the bank’s liquidity position;and the intensity of funding needs. These “organic”variations can cause dramatically different assumptionsabout the proportions of loyal vs. migratory (rate-seeking) balances, and valuation applied to the balances.

Furthermore, these organic variations are beingmagnified by sharply differing FTP methodologies,creating an enormous deposit valuation spectrumamong major banks. Underscoring the starkdifferences in valuations, among 14 respondents to theFTP portion of the Novantas 2008 Deposit PricingBest Practices Survey, there was a 239 basis-pointdispersion of FTP valuations on MMDAs, and therewas a 180 basis-point dispersion of FTP valuationson CDs.

Though never inconsequential, the competitiveimpact of such dramatic variations at least was moretolerable in years past, when deposit funding was moreprominent. Going back to the severe lending downturnof the early 1990s, for example, U.S. depositoryinstitutions held roughly $90 of loans for every $100of core domestic deposits. At midyear 2008, bycontrast, the loan-to-core deposit ratio hadskyrocketed to 135% — $135 of loans for every $100of core domestic deposits. During the same timeperiod, net interest margins have dwindled fromroughly 4.50% to less than 3.50%.

In the current situation, where margins are underassault and banks have lent way beyond their depositbases, traditional FTP approaches have contributed tomore than a few situations where major banks have

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underpriced deposits relative to their funding needs. Atthe other end of the liquidity spectrum, a few well-funded banks have forfeited precious margin byovervaluing deposits relative to their needs.

THREADING THE MAZELeading institutions are threading this maze bymarshalling treasury and retail resources in independentand joint investigations. Treasury is building a clearpicture of the balance sheet situation, while the businesslines are refining their understanding of customerdeposit price elasticity. Together they are incorporatingthese insights into fresh, detailed observations ofcustomer behavior — by market, product, term, andbalance tier — to develop refined repricing and liquiditycalculations for FTP usage.

These management and analytical advances enablethe institution to:

• Project deposit repricing behavior.• Estimate deposit balance retention in normal

and stressed scenarios.• Assess the degree of optionality in the portfolio,

or the extent to which customers mightterminate or extend accounts depending onrate movements.

• Measure the cost to hedge potential adverseoptionality.

• Calibrate “liquidity premia,” or internal creditsassigned to loyal balances.

Typically, two major performance problems come tolight once institutions complete this extensivegroundwork. First, it becomes clear that many

decisions on deposit and loan formation are beingmade to the detriment of the net interest margin.Second, it becomes clear that resources often are beingmisdirected among business lines, with deposit-gathering activities typically undervalued relative toasset generation.

The good news is that the upside potential inaddressing these problems is significant. Yet a carefully-planned management framework is needed to take fulladvantage, entailing much higher treasury/retailcoordination than seen in the past.

Facing increasing stresses on balance sheets,continued narrowing margins, and fierce competition,financial institutions have ample reason to rethinktheir FTP methodologies. While the deposit business isan area of prime concern, it ultimately is part of alarger picture that should be reviewed as well.

Information and analytics that were not available 20years ago, when FTP was becoming more formallyestablished at larger banks, now should be incorporatedto improve decision-making at this critical time.

With these adjustments in place, the bank will bein a position to make better deposit and loan pricingdecisions; value these same assets and liabilities moreeffectively; and develop greater insight on the behaviorof competitors.

Steve Turner is a managing director in the New Yorkoffices of Novantas LLC, a management consultancy.

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