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Every month, management control and FP&A teams rank products, business areas, regions and branches, and those rankings feed budgets, targets and bonus pools. If the margin behind the ranking leaves out part of what the money costs, the bank rewards the wrong units and grows where it earns least.
The rate cycle of 2022 and 2023 made the problem harder to see. As net interest income climbed across most of the industry, many institutions could not easily say how much of the increase came from commercial activity and how much from the level of rates, and every unit looked better than its real margin.
This article examines how funds transfer pricing (FTP) changes which products, areas and branches look profitable, why targets set on volume push the wrong kind of growth, and how a contribution margin calculated contract by contract can be read along every dimension the bank manages.
A Branch Full of Cheap Deposits Can Look Like the One to Shrink
A teaching case published by the IMA Educational Case Journal shows how far a profitability ranking can move. The case is built around a fictional bank. Its retail segment gathers large volumes of cheap deposits, yet under the bank's transfer pricing it appears as the least profitable segment of the group. It is credited only the funding rate on those deposits, while the maturity transformation spread earned by lending that money out for longer accumulates in treasury.
The business that funds the bank most cheaply looks like the one to shrink.
The same arithmetic applies to a branch network. A branch whose customers hold large, stable balances and borrow little can rank near the bottom if the funding value of its deposits is not credited to it, while a branch that lends heavily on underpriced mortgages ranks near the top. Management then does what the ranking suggests: it adds targets and resources to the second branch and questions the first.
Why Does the Accounting Margin Misrank the Network?
The accounting margin misranks the network because it charges every product the same cost of money. Set against one average funding rate, a 30-year mortgage is charged what a one-year loan is charged, whatever its term, its liquidity or the options its customer holds.
When the yield curve slopes upward, as it usually does, that average distorts the ranking in a predictable direction. It charges short-term lending more than its money costs and long-term lending less, and it credits stable deposits with less than the funding they provide is worth. Short products and deposit-rich units look worse than they are. Long products look better.
The Contribution Margin Is a Subtraction
FTP corrects the distortion by giving every loan and deposit its own internal price, the FTP rate: the real cost the money has for the bank. As what funds transfer pricing really measures explains, the FTP rate is a base rate taken from the yield curve plus a set of FTP spreads that each institution defines for itself; a liquidity spread, an optionality spread and a regulatory spread are one example. The rate the bank applies minus the FTP rate is the contribution margin.
A 30-year mortgage priced at 4% against an FTP rate of 3% leaves a contribution margin of 1%, in round, illustrative numbers. Now suppose the optionality spread, which pays for the borrower's option to repay early when rates fall, is left out. The FTP rate falls below 3%, and the reported margin rises above 1% by exactly the amount left out. The mortgage has not changed; only the measurement has.
Álvaro Nieto, Head of Product at Mirai, states the consequence directly:
It is not enough to look at the margin we earn from the interest rate. We have to subtract the different funding costs, such as the FTP base rate and the cost of liquidity, to see the real commercial margin.
How Can Banks Measure the Real Margin Behind Every Loan and Deposit?
Products Sold at a Loss Can Rank Near the Top
The most direct cost of an incomplete FTP rate is a product that looks profitable on the margin the bank measures and loses money on the margin it earns. Nieto describes the pattern from client work: an institution that does not charge its mortgages the regulatory cost of granting them, nor account for how each new mortgage affects its ratios, can end up granting a very high volume of them that turns out to be negative for the bank.
Pricing starts from the cost the bank sees, so when the regulatory cost is missing, the price looks adequate and the product sells well. Commercial success then adds volume to a book that loses money on every new contract, while each new mortgage uses up room in the ratios that nobody has priced. In a ranking built on that margin, the branches selling most of those mortgages sit near the top.
Nieto draws the line from the single product to the whole network:
Getting FTP wrong can lead us to sell products at a loss, or to lose focus on the products, areas and locations where we are most profitable.
Targets Decide What the Network Sells
FTP decides what each unit is seen to earn, and what a unit is seen to earn sooner or later becomes what it is asked to deliver. When the margin behind budgets and rankings is an accounting figure, the target that follows is usually set on volume or revenue. The Bank for International Settlements (BIS) Financial Stability Institute, surveying liquidity transfer pricing at 38 large banks, found bonus pools that were often a simple percentage of accrued revenue, calculated with no regard for the liquidity risk the business had taken. A loan officer paid on volume sells volume, including the mortgage that loses money.
FTP changes the number people are judged on. SouthState Correspondent Division describes how FTP divides a bank's net interest margin into one sub-margin for deposits and another for asset origination so that the bank can reward loan officers, branch managers and regional leaders on margin contribution rather than on volume or revenue. Under a volume target, a regional head asks a branch manager how much was sold this quarter; under a contribution margin target, the question is what was sold, at what price and with what funding behind it.
Targets set on volume push growth, while targets set on contribution margin push profitable growth.
Having FTP Is Different From Being Measured on It
Many banks already run some form of FTP, although running it and steering with it are different things. In a survey published in the Scandinavian Journal of Management in September 2018, Viktor Elliot gathered 99 responses from 28 of Sweden's 31 savings banks. He found FTP widely implemented but unsophisticated.
In Nieto's experience, banks rarely pay for this gap through poor execution. "They pay for it through poor measurement," and the bill arrives as products sold at a loss, commercial effort placed where the bank earns least, and targets and rewards that follow the wrong number.
One Margin per Contract, Read Along Every Dimension
A ranking the network can trust starts at the finest level of detail the bank holds. A real FTP calculates the base rate and each FTP spread for every contract, on real yield curves, real behavioral assumptions and market-standard methodologies, and it charges each cash flow at the term that applies to it rather than at an average for the whole balance.
Once that result exists, the margin by product, segment, business area, region, branch or manager no longer has to be estimated separately or rebuilt in a spreadsheet for each committee. Each is a way of analyzing the same contract-level figure, so two committees looking at the same branch see the same number. In a view by branch, a branch that gathers cheap deposits is credited the funding value those deposits provide, because each deposit is credited for the funding it provides, through the spreads the institution defines. In a view by product, the contracts whose rate does not cover their FTP rate stand out.
The same result separates commercial performance from the rate effect, because the base rate charge removes the part of the customer rate that reflects where rates stand. Whichever way rates move next, a contract-level margin keeps the rate effect apart from what each branch actually earns.
The whitepaper Funds Transfer Pricing as a Steering Mechanism explains how that contract-level margin is calculated and kept current every night, as a fully automated process from the bank's source systems back into its operational systems. At one client, a global systemically important bank (G-SIB), the calculation processes millions of contracts in about 30 minutes.
What Changes When Management Reads the Real Margin
When the real margin can be read by dimension, a regional head can compare the branches in the region on the same basis, and a product manager can see which contracts pull a portfolio's margin down and which component of the FTP rate explains it. Three actions follow from that view:
- repricing products whose real margin is thin or negative, or limiting their volume, before more of them reach the book
- redirecting commercial effort toward the products, business areas and branches that earn most once the full FTP rate is counted
- setting objectives for business areas, branches and managers on the real margin rather than on volume or revenue
The third action closes the loop on incentives. A branch manager whose targets rest on the projected real margin can see, before agreeing to a campaign, whether it will add to what the bank earns or only to the volume it books.
Institutions that rank their network on the real margin will put targets, resources and rewards where the bank earns. Those that rank it on the accounting margin will keep backing the branch that sells the most and questioning the branch that funds the bank.
The Mirai Platform is an example of this approach in practice. It brings FTP, balance sheet management and regulatory compliance together on one platform, fed by one data load and run on one set of assumptions, so the margin a branch is judged on and the liquidity its deposits provide describe the same bank.
For the full framework, from the base rate and FTP spreads to contribution margin by product, area and branch, calculated overnight and tested with what-if strategies, see Mirai RiskTech's whitepaper Funds Transfer Pricing as a Steering Mechanism: how banks measure and steer the real margin.
