The Transfer Pricing Quandary

We have experienced an unprecedented, extremely stable, low rate environment in the past four years. The Fed cut rates in rapid succession numerous times, and they remained low. This change has had many positive impacts, but it also wreaked havoc in transfer pricing systems everywhere.

Transfer pricing is that methodology (some say art) by which CFOs and treasurers allocate interest expense to loans and interest yield to deposits. It can turn a silk purse into a sow's ear in an instant, since every 10 basis points of yield or cost make a huge difference in the profitability of the product impacted. The impact of transfer pricing dwarfs all other elements in the product profitability equation. Cost allocations are important, but transfer pricing is king.

As rates declined precipitously and then remained low, deposits became much less attractive as a source of funding relative to other, wholesale alternatives. Banks could borrow more cheaply than they could raise deposits, an unusual situation that has remained true for years now. CFOs across the industry started asking the question: who needs deposits when FHLB advances and brokered deposits are so much cheaper?

Further, some banks discovered the only limitation of non interest bearing checking accounts: you can't go below zero on their pricing. In fact, free checking balances turned from highly attractive to ho-hum in many banks. Some realized that zero is really a fixed rate price. The value of interest-free deposits when fed funds were 4% was dramatically higher than when funds are at 1%.

The result of this sea-change has been deposit product profitability analyses nationwide that show that deposits are huge losers. No branch can make money when its transfer priced interest income is a negative number. This happens often when FHLB and other wholesale funding sources are now less expensive than deposit prices, including money market accounts, and certainly CDs.

While everyone knows this is temporary, the picture becomes more entrenched each day, and is certainly firm after four plus years of this aberrational rate environment. Heads of retail banking in most banks are frustrated with the poor financial results their business yields, and many abdicate their high-cost deposits, such as CDs, to rate surfing institutions and internet banks.

The real issue behind this change is that long term decisions are made based upon information that reflects medium-term rates. Branches are being closed and others opened, using mathematically accurate formulae that yield the wrong decision for the bank in the long run. In order to ensure that your management team is making the right decisions regarding its deposit franchise, ask the following three questions:

1. Are you using spot or rolling rates to transfer price your deposit values?

   In most banks deposits get the benefit of the cost of funds they save over other sources of funds. This is the prevailing methodology for determining the transfer price for all deposit products. However, when such margin is negative (using today's rates, and the rates over the past four years as well), even low cost, franchise-value building deposits turn from winners to losers. The question you should ask is: Are we using daily rates to match-fund all our indeterminant maturity (deposits without a specific maturity, i.e. non CDs) deposits? If so, your deposits will continue to show losses relative to other sources of funding.

   An alternative to consider is a rolling average rather than spot rates. The real question is: how long should that rolling average be.

2. How long should your rolling average be?

   Many banks acknowledge that spot rates are inappropriate to apply to deposit categories such as savings, checking and money market. However, they choose rolling averages that are often arbitrary. Again, the length of the rolling average maturity  1 month, 12 months or longer  makes an enormous difference in the implied profitability of the deposit product. Hence, an important question to ask is: what should be the right methodology to determine the rolling average length? I recommend using your own historical experience regarding the tenure of your various deposit products. It's much easier to use arbitrary figures, but it is less accurate.

3. What about franchise value?

   Deposits do have franchise value. Unlike wholesale funding, they commend a premium in the marketplace, ranging from a very low 2% to high-cost, non-relationship CDs to over 20% for core, solid relationships. Should this element be taken into account when your deposit profitability is determined? This is the third question you need to ask.

The purpose of transfer pricing and product profitability analysis is to ensure that management has a solid understanding of the profitability ramifications of its decisions. Making sure that your transfer pricing methodology is not only accurate but also correct is a critical step in the process.