28 CREDIT UNION MANAGEMENT JUNE 2008

BY OrlandO B. Hanselman

do you know where your credit union’s profits come from? Do you know which products or mem-

bers create value and which destroy it? Sadly, most CUs today do not have measured answers to these questions. And too often the intuitive answers they do have are wrong or misleading. Most CUs price loans and shares to mimic their competitors, institutions that have different strategies, goals, risk tolerances and cost structures. Increas-ingly, however, CUs wishing to create a winning competitive advantage use matched-term funds transfer pricing. Funds transfer pricing is an internal management information system and methodology designed to allocate net interest margin between funds users, such as lenders and investment officers, and funds providers, including branch share gatherers and financial officers responsible for obtaining other sources of liquidity funding, such as borrowings. FTP is a rigorous measurement and pricing method based on the pretense that all funds are bought and sold in an open market. FTP establishes a frame-work for net interest margin allocation by incorporating this market pretense concept within an organization. Using FTP, all funds move through a centralized “warehouse” commonly referred to as the “funding center.” Branches sell gathered member shares into the funding center at a market-based transfer pricing rate. “Transfer pricing” refers to the pricing of contributions (tan-gible and intangible assets, services, and funds) transferred with in an organiza-tion. For example, to originate loans or purchase investments, lenders and inves-tors buy funds from the funding center at a market-based transfer rate; funds-

gatherers, such as deposit takers at branch locations, are in turn paid an appro-priate transfer rate. In addition to being a central funds warehouse, the funding center is responsible for centralized measurement and manage-ment of the CU’s aggregate mismatch risk position, which is composed of inter-est rate and market risk. With the FTP measure-ment process, a CU knows the detailed components of and contributors to the organizational net interest margin, and has a clearer picture of its overall sources and levels of risk.

The Basics

So how does FTP work, exactly? Financial instrument by financial instrument, each source of funds, such as a share or borrowing, and each use of funds, such as a loan or investment, is valued at the time of origination. This valuation is accomplished by assigning each financial instrument an associated “transfer rate” from an appropriate transfer pricing curve. Transfer curves are best selected from a variety of market-based interest rate curves, such as the LIBOR (London InterBank Offer Rate) or U.S. Trea-sury yield curve. The funding center determines the value to be paid to fund providers and the cost to be charged to fund users from the transfer rate curve. The associated transfer rate mirrors as

closely as possible the underlying instru-ment’s cash flows, repricing and optionality attributes. This assigned transfer rate is wed to the financial instrument and does not change until the financial instrument matures or reprices. The allocation of the CU’s net interest margin is accomplished by this instrument-by-instrument valua-tion. By tallying the numerous instruments’ individual valuations, the CU can effec-tively aggregate FTP results at the total organizational, business unit, product and member levels. Assigned transfer rates must match the financial instrument as closely as possible. Cash flow, repricing and maturity of the instrument will be used to determine the appropriate point on the transfer curve(s) to find the transfer rate. While financial instruments with indeterminate maturity—such as credit cards, open lines of credit and checking accounts—pose an additional chal-lenge, several methods for effectively estimating their maturity have become

Funds TransFer PricingAllocating net interest margin among funds users and providers gives CUs numerous benefits in strategic planning and pricing.

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well accepted within the industry. If the underlying financial instrument has a fixed rate, the transfer rate should be a fixed rate. Adjustable-rate financial instruments should have a transfer rate that changes upon the instrument’s reset date. Floating rate instruments should have a floating transfer rate. Financial instruments that amortize should have a transfer rate that considers amortiza-tion. Finally, if the underlying financial instrument allows for prepayments or early withdrawals, the transfer rate should do the same.

applying FTp Knowledge

Using the information gathered through the FTP process, CUs can adjust derived transfer rates and design special product promotions to help them more effec-tively reach growth and balance goals by

providing appropriate incentives for desired business unit and employee behaviors. The CU’s need to rebalance risk expo-sures, such as lending concentrations, may also be facilitated by temporary strategic transfer rate adjustments. For example, if the CU wants to limit further auto lending for risk concentration rea-sons, the transfer charge for underwriting more auto loans would be increased beyond the stated market-based transfer rate. With this strategically higher cost of funds, lenders would clearly under-stand that auto loans are currently less desired by executives. Should lenders still decide to make new auto loans without upwardly adjusting member rates, the FTP dis-cipline would result in higher funding costs, less net interest margin, lower lending unit profitability and poten-tially lower incentive compensation. Alternatively, the lenders may opt to

continue auto lending while still adher-ing to their budgeted profitability goals by charging the member a higher loan rate to compensate for the increased funding cost, thereby better rewarding the CU for the additional risk that they are taking on and would otherwise prefer to avoid. With this process, the CU has powerfully aligned its lenders’ decentralized actions with the CU’s risk tolerances. Faced with these choices, the lender must consider whether it is in everyone’s best interest to make the loan at the higher risk-adjusted rate or not to offer the loan at all. This is a service issue for which FTP helps to measure the economic impact. CUs choose to make these elective adjustments based on their unique strategies, goals and risk tolerances as well as by how much the factors being considered impact the net inter-est margin and profitability.

30 CREDIT UNION MANAGEMENT JUNE 2008

Three Key BucKeTs

While each CU measures and reports its total net interest margin, only those using FTP are able to explain and quantify these three sources of net interest margin contribution: credit spread, deposit franchise spread (the branch’s income contribution for effi-ciently and cost effectively obtaining member shares) and mismatch spread. Improved margin accountability and enhanced segregation of duties are achieved with FTP because we now have three discrete management buck-ets, each containing segregated risk, return and responsibility. The lender bucket holds assumed credit risk with resulting credit spread return and establishes exclusive lender accountability for managing the CU’s credit risk. The branch bucket holds assumed liquidity risk with the result-ing deposit franchise spread return and establishes exclusive branch responsi-bility for cost-effectively obtaining the appropriate amounts of retail funding just in time as needed. And finally, the funding center bucket holds assumed interest and market risk with the resulting mismatch spread return and establishes exclusive responsibility for macro-management of the CU’s inter-est and market risk. Instead of everyone indirectly responsible for the CU’s total net interest margin, we now have three separate groups of employees each directly responsible and measurably accountable for one key contribut-ing margin element. Accordingly, the CU avoids the well-known manage-ment trap when everyone seems to be responsible, but in reality no one can be held responsible. As a result of this process, the CU has achieved the first critical step in mea-suring its business unit, product and member profitability. Without FTP, a typical branch’s income statement is primarily composed of fee income, share expense, overhead expenses and some direct loan income. However, the major source of a branch’s economic contribution to the CU, which can only

be measured with FTP, is the deposit franchise spread earned on its generated shares. Without assigning a market-based value to funds provided to the branches, a CU will only capture the interest cost paid for the member funds, essentially ignoring the quantified value of each source of funds to the CU. Likewise, a lending unit’s income statement without FTP is primarily composed of loan income, credit losses and overhead. Lending units are not assessed a cost of funding for the loans they make, much akin to selling cars without paying for the steel used in manufacturing. It is only through use of an FTP system that business unit profitability can be properly measured and there-after appropriately managed. Once each financial instrument has an asso-ciated transfer cost or value, product and member profitability becomes the aggregation of all allocated net inter-est margin dollars associated with the applicable underlying instruments.

sound sTarTing poinT For pricing

Each CU may now use these FTP insights to provide optimal custom-ized loan and share pricing. Such optimal pricing begins with the FTP-derived cost of funds used or value of funds provided plus consideration of elements specific to each CU: costs of business operations, goals and strate-gies, and embedded transaction risks. Our optimal customized loan price would be determined by this formula: FTP cost of funds used + fixed and variable lifetime costs associated with the loan + cost of assigned capital based on all embedded risks (credit, interest rate, market, liquidity and operational) related to the loan as well as specific to the member + stra-tegic return expected. For shares, the formula for opti-mal customized pricing is: FTP value of funds provided minus fixed and variable lifetime costs associated with the share minus cost of assigned capital based on all imbedded risks

(interest rate, market, liquidity and operational) related to the share minus strategic return expected. These FTP-based formulae deter-mine a CU’s unique and optimal price, which provides an economic risk-adjusted profit as well as book profit at the strategic return rate expected. From this suggested optimal price, fur-ther tailored pricing refinements may be considered, such as the member’s loyalty and price elasticity as well as specific value-added product features. The local competitive market as well as the CU’s balance sheet needs and risk positioning must also be consid-ered prior to finalizing the price. Best practice FTP requires CUs to assign a market-based contribution value to funds provided and used. The value is determined by assessing each individual financial instrument at the time of origination. It is also essential that your FTP system be understandable, explainable, consis-tent, well documented and credible with users. Your FTP system must be customized to your unique CU. High-performance CUs wishing to create a winning competitive advantage use FTP’s insights to create strategic value and optimize net interest margins.

orlando B. hanselman is education programs director of the IPS-Sendero Institute (www.ips-sendero.com). Reach him at orlando.hanselman@ips-sendero.com.

RESOURCESread two Web-only bonus articles at cumanagement.org. choose “June 2008” from the “Past issues” pull-down menu. Credit Union Management magazine’s “cFO Focus on Line” column runs the first Thursday of every month on cues.org. Find past installments and other articles about finance at cumanagement.org. choose “articles by Topic” then “Operations” and finally “Finance.” Hanselman will present at cues annual convention, slated for June in cancun. Learn more and register at cues.org/cac/.