Funds Transfer Pricing (FTP) is a financial management technique used by financial institutions to allocate the interest rate risk and spread income among different business units within the organization. The goal of FTP is to measure the contribution of each business unit to the overall profitability of the institution and to ensure that each unit is adequately compensated for the risks it takes.

Key aspects of Funds Transfer Pricing include:

1. **Interest Rate Risk Management:**
– FTP is used to allocate interest rate risk across various business units. It helps in assessing how well each unit is managing its interest rate exposure and whether it is adequately compensated for the risks it takes.

2. **Cost Allocation:**
– FTP allows financial institutions to allocate the cost of funds to different business units. This includes determining the cost of obtaining funds from various sources, such as deposits or wholesale markets, and assigning these costs to the units that use those funds.

3. **Profit Attribution:**
– By assigning costs and revenues to individual business units, FTP helps in attributing profits to each unit. This allows management to evaluate the performance of each unit independently and make informed decisions about resource allocation.

4. **Risk-Adjusted Pricing:**
– FTP enables risk-adjusted pricing by considering the risk profile of each business unit. Units taking higher risks or engaging in riskier activities may be charged a higher cost of funds or required to contribute more to the overall profitability.

5. **Capital Allocation:**
– In addition to interest rate risk, FTP may also be used for allocating capital costs. This involves assigning a portion of the institution’s total capital to each business unit based on the capital required to support its operations and risks.

6. **Market-Based Pricing:**
– FTP often uses market-based benchmarks and rates to determine the cost of funds. This ensures that the internal pricing reflects prevailing market conditions and encourages business units to operate in a manner consistent with external market expectations.

7. **Decision Support:**
– FTP provides valuable information for decision-making within the organization. It helps management understand the drivers of profitability, assess the impact of interest rate changes, and make informed decisions about strategic initiatives and resource allocation.

8. **Regulatory Compliance:**
– Financial institutions are often subject to regulatory requirements regarding the allocation of capital and risk. FTP helps ensure that the institution complies with regulatory expectations and provides transparency in the allocation of costs and profits.

9. **Performance Measurement:**
– FTP facilitates performance measurement by allowing the organization to track the financial performance of each business unit over time. This includes assessing how well units meet their financial targets and contribute to the overall success of the institution.

FTP is particularly relevant in the banking sector, where financial institutions have diverse business lines, each with its own risk profile and funding needs. Effective FTP practices contribute to better risk management, enhanced decision-making, and a more accurate assessment of the true economic value generated by each business unit.