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Cost of Funds in an FTP Model

October 2, 2013
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We all know that an institution earns income primarily from the interest spread between earning assets (loans) and deposits. The LoanEDGE pricing model calculates loan income by considering loan interest and fees. But it does not calculate loan expense (funding expense) by using your cost of deposits. We use funds transfer pricing methodology (FTP) to calculate the cost of the funding that supports a loan. The cost is calculated by balance weighting the rates from the wholesale funding curve attached to your accounts using the principal balances necessary to support the loan. FTP theory is based on the recognition that both lending and deposit gathering activities are economically valuable to an institution. We trust that lending is valuable because it usually earns a yield above our cost of the related funding. We know deposit gathering is valuable because funds can be acquired at rates less than what we would have to pay in a wholesale market by borrowing the funds. Deposits are also valuable because non maturity deposit actual durations are longer than the contractual duration and they also tend to have lower pricing responses to market rate increases. FTP measures the independent contributions of loans versus deposits by comparing each to an independent wholesale cost of funds. We typically use an FHLB borrowing rate curve for the district in which an institution is located as the best available wholesale rate curve. But it is possible, if appropriate, to use other rates such as a brokered CD market curve, a swap curve, or a corporate bond curve. By using an independent funding curve we can measure the spread between the deposit cost and the curve, then between the curve and the loan income. Because durations of loans and deposits will vary, the FTP method also helps us assess the inherent interest rate risk and option risk reflected by a curve comparison. The following graphic illustrates four separate spread components that FTP methodology attempts to measure.

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Before FTP was widely used, it was typical to express this loan as having a 4% spread to its cost. But when we look at the components of the spread this way, we see that the spread is really a result of four economic variables that affect a retail financial institution.

The deposit spread represents the difference between retail deposit cost and wholesale funding cost.
The rate risk spread represents the interest rate risk embedded in the loan due to its longer duration.
The loan may have option risk, such as a prepayment option that a borrower will exercise if rates decline. A well-priced loan will have a spread that compensates the institution for providing this option.
Finally, the loan spread is the rate differential that can be earned by lending at retail rather than at wholesale, and is needed to cover operating expenses and credit risk inherent in retail loans.
So when we calculate the funding cost of a loan in LoanEDGE, we are essentially using the rates on the red line to reflect the deposit-neutral cost of the funding that is necessary to support the cash flows of the loan. Since most loan principal cash flows occur over time because of payment amortization, the actual cost calculated is weighted along the funding line depending on when the cash flows occur.

To learn more about loan pricing, watch this on-demand webinar, "Loan Pricing: A Key Driver of Success." 

*Some of the solutions or services mentioned in this post may no longer be offered. For information on alternatives, please go to visit Abrigo Advisory Services.
 

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