FTP fundamentals: the most important internal price in banking

FTP Fundamentals: The Most Important Internal Price in Banking

Funds Transfer Pricing (FTP) is how banks allocate interest rate risk to business lines. It's the internal price at which the treasury department (the center) "lends" funds to the mortgage business, "borrows" deposits from the retail business, and manages the overall balance sheet.

FTP sounds technical, but it's actually strategic. It directly determines which businesses are profitable and which lose money. Change FTP rates by 50bps, and a mortgage business that was earning 45% RAROC becomes marginally profitable. Get FTP wrong, and management makes terrible business decisions based on false profitability.

Why FTP Matters

Without FTP, here's what happens: A customer deposits $100K. The retail banking group books this as a deposit. A mortgage customer borrows $400K. The mortgage group books this as a loan. The interest income flows to whoever "owns" the asset or liability.

But where's the interest rate risk? If rates rise, the fixed-rate mortgage doesn't reprice while deposit costs might increase. Someone bears this risk. In most banks without FTP, it's the mortgage business that bears the rate risk, even though the retail banking business collected the deposit.

With FTP, the center (treasury) extracts the rate risk by:

• Charging the mortgage business an FTP rate when they originate a loan


• Crediting the deposit business an FTP rate when they gather deposits


• The center bears all interest rate risk

Now the mortgage business is evaluated on spread over FTP rate, not on absolute profitability. The deposit business earns the margin between customer rates and FTP rates.

Real Example: FTP in Action

Consider a 5-year fixed-rate mortgage:

• Customer rate: 6.5%


• FTP rate for 5-year funds: 4.8%


• Mortgage business earns: 1.7% spread (170bps)


• This spread must cover origination costs, losses, and profit

Compare this to the same mortgage without FTP:

• Customer rate: 6.5%


• Customer rate-funding cost (say, 3.2% cost of funds): 3.3%


• Mortgage business shows 3.3% spread

But the 3.3% spread is misleading. It includes the bank's entire interest rate view. If rates rise and deposit costs spike to 4.5%, the mortgage business suddenly looks terrible (earning only 2% spread) even though nothing changed about the loan itself.

With FTP at 4.8%, the mortgage business consistently earns 170bps regardless of where rates go. Rate risk is explicitly priced.

The Three Core Uses of FTP

1. Profitability Assessment: Which business lines actually make money? With FTP, you know mortgage business makes 170bps over FTP, deposit business makes the spread between customer rates and FTP.

2. Pricing Decisions: When you originate a new mortgage, you know you need to price at least FTP + your margin to avoid losing money. If FTP is 4.8% and your cost structure needs 150bps margin, you price at 6.3% minimum.

3. Risk Management: FTP rates incorporate the cost of funding for different tenors. If 5-year FTP is 4.8% but 7-year FTP is 5.1%, it's more expensive to fund long-duration assets, which should be reflected in pricing.

FTP vs. Actual Funding Cost

This is a critical distinction. FTP rates are often different from the bank's actual weighted-average cost of funds.

• Actual cost of funds: 3.2% (weighted average across all deposits and wholesale funding)
• 5-year FTP rate: 4.8%
• Difference: 160bps

The difference exists because: 1. FTP rates incorporate interest rate risk premium (longer-term funding costs more) 2. FTP rates may include a capital allocation component 3. FTP rates may include a profit margin for the treasury function

A bank with 3.2% cost of funds but 4.8% FTP rates is essentially charging business lines 160bps for the privilege of accessing funds. This is intentional—it creates a spread for the treasury function and incentivizes business lines to be capital-efficient.

Understanding Your Bank's FTP Curve

FTP is quoted as a curve: different rates for different tenors. A typical curve might be:

• 1-month: 4.5%


• 3-month: 4.6%


• 6-month: 4.7%


• 1-year: 4.8%


• 2-year: 4.9%


• 5-year: 5.0%


• 10-year: 5.2%

The curve shows that longer-duration funding is more expensive (upward sloping). This reflects:

• Interest rate risk (longer duration = more rate risk)


• Liquidity risk (longer-term funding is less liquid)


• Funding market conditions (if long-term funding is scarce, costs more)

When the market yield curve inverts (short rates higher than long rates), an inverted FTP curve signals that short-term funding is genuinely more expensive than long-term funding.

FTP Fundamentals: The Strategic Deep Dive

The Mathematical Foundation of FTP

FTP rates are typically derived from one of two methods:

Market-Based FTP:

• Take current market rates for funding (from Treasury markets, SOFR curves, etc.)


• Add a spread for credit risk (bank's own credit spread in the wholesale market)


• Adjust for average balance dynamics


• Result: FTP curve that reflects market reality

Example calculation:

• 5-year SOFR swap rate: 4.5%


• Bank's 5-year wholesale borrowing spread: 40bps


• 5-year FTP rate: 4.5% + 0.4% = 4.9%

Cost Plus FTP:

• Take actual cost of funds (weighted average of all deposits and borrowings)


• Add spread for capital allocation


• Add spread for treasury function profit


• Result: FTP rate that covers actual costs plus margin

Example calculation:

• Actual cost of funds: 3.2%


• Capital allocation spread: 0.8%


• Treasury function profit: 0.4%


• 5-year FTP rate: 3.2% + 0.8% + 0.4% = 4.4%

Most banks use market-based FTP because it's more objective and captures rate risk accurately.

The Customer Rate vs. FTP Decomposition

When a customer gets a 6.5% mortgage rate, it's decomposed as:

Customer Rate = FTP Rate + Business Line Spread

6.5% = FTP Rate + Business Line Spread

The FTP rate is determined by treasury and market conditions. The business line spread is determined by:

• Cost of origination (loan officer time, systems, compliance)


• Expected credit loss (provision for charge-offs)


• Operating cost (servicing, customer service)


• Targeted profit margin

If FTP is 4.8% and the mortgage business needs 170bps spread (origination cost 50bps + expected loss 30bps + operating cost 50bps + profit 40bps), the customer rate is 6.5%.

Now, if rates rise and FTP increases to 5.1%, the mortgage business still needs 170bps spread, so customer rate becomes 6.8%. The customer sees the rate increase (because FTP increased), but the business line's profitability on spread remains constant.

Without FTP, if rates rise but the mortgage business "inherits" the rate increase without a corresponding pricing adjustment, the business line's spread compresses unfairly.

Deposit Funding and FTP

Deposits are the other side of FTP. When the retail banking group gathers a non-interest-bearing deposit, FTP credits them at a rate.

Deposit FTP Mechanics:

• Non-interest-bearing deposits get credited at the "overnight" or money market rate


• Interest-bearing deposits get credited at the deposit's repricing rate plus a spread


• Certificates of deposit get credited at the fixed deposit rate

Example:

• Non-interest-bearing deposit: Credited at overnight SOFR (3.25%)


• Savings account (0.5% paid to customer): Credited at 0.5% + deposit margin (say 0.3%) = 0.8%


• 2-year CD (4.2% paid to customer): Credited at 4.2%

The retail banking group earns the spread between what they credit (FTP) and what they pay the customer. If they can gather deposits for 0.5% and FTP credits them at 0.8%, they earn 30bps.

If FTP moves to 1.0%, the 30bps spread disappears (they now credit at 1.0% but still pay customer 0.5%, losing 50bps). The center (treasury) is better off (higher rates), but the retail business is worse off.

Real Example: FTP Impact on Business Line Economics

2024 Scenario: Mortgage origination with changing FTP

January 2024 (5-year FTP: 4.2%):

• Customer rate: 6.0%


• FTP rate: 4.2%


• Business spread: 1.8%


• Expected annual profit on a $400K mortgage: ~$7,200 (1.8% of $400K)

April 2024 (5-year FTP: 4.8%, rates rose):

• Market mortgage rates: 6.5%


• FTP rate: 4.8%


• Business spread: 1.7% (customer rate rose but not as much as FTP, because competition compressed margins)


• Expected annual profit on a $400K mortgage: ~$6,800

Interpretation: Even though FTP increased, the business spread compressed slightly due to market competition. But without FTP, the mortgage business would show huge profit declines because they'd be funding at a higher cost without ability to reprice customer rates.

With FTP, the profitability decline is modest because FTP isolates the business from wholesale funding rate movements.

FTP and Capital Allocation

Some banks add a capital component to FTP:

FTP with Capital = Base Rate + Capital Spread

Where:

• Base rate: Market-based (4.8%)


• Capital spread: 0.6% (reflecting capital cost for the business)

Total FTP: 5.4%

The capital component recognizes that different businesses consume capital differently:

• Mortgages: Low risk, lower capital spread (maybe 0.3%)


• Commercial loans: High risk, higher capital spread (maybe 0.8%)

A business line's profitability then reflects both interest rate spread AND capital efficiency.

FTP and Hedging Decisions

Once FTP rates are set, the treasury function uses those rates to hedge the balance sheet.

If the FTP curve shows:

• 5-year FTP: 4.8%


• 10-year FTP: 5.1%

Treasury might hedge the 10-year duration risk by receiving fixed at 5.1% in a swap. This locks in the rate and ensures mortgages originated at FTP will be fully funded.

Without this hedge, mortgage originations (funded via FTP) would be unhedged if FTP doesn't match actual funding cost.

FTP Governance and ALCO

FTP rates are set by the treasury/ALM team in coordination with ALCO. The governance structure typically:

1. Treasury proposes FTP rates based on market data
2. Business line heads review and comment on impact
3. CFO and chief risk officer approve based on:
- Market reasonableness (are rates fair?)
- Impact on business profitability (are rates too punitive?)
- Strategic objectives (do rates incentivize desired behavior?)
4. Rates are implemented and used for all new originations

FTP rates are typically reset monthly or quarterly based on market conditions. If rates move 50bps, FTP moves similarly.

FTP and Profitability Management

A key insight: Business line profitability is often driven more by FTP setting than by business line execution.

Example: Commercial loan business

• If FTP is set low (favorable): Business line shows high profitability


• If FTP is set high (punitive): Same business line shows low profitability


• The actual credit risk and origination quality of loans is the same

This is why FTP governance is critical. A CFO who wants to boost "commercial lending profits" might pressure treasury to lower FTP rates for commercial loans. But this doesn't create real profit—it just shifts profit from the center (treasury) to the business line.

Smart banks use FTP to incentivize behavior:

• Want to grow mortgages? Lower the FTP rate for mortgages, making them more profitable


• Want to encourage deposit gathering? Keep deposit FTP rates low, making deposits more profitable


• Want to discourage low-return businesses? Raise FTP rates, making them less profitable

For ALM managers, the lesson is: FTP rates are your primary tool for shaping business line behavior. Master FTP setting, and you master the entire balance sheet strategy.