Business Units Squabble Over In-House Rates

It's buyer beware within banks these days.

Transfer pricing, the rates bankers charge for funds and services sold to departments inside the bank, is getting a lot more scrutiny now that cutbacks and layoffs are often tied to departmental performance.

"The pressure is on to make those prices market-driven," said management consultant Jean-Louis Lelogeais, a partner at Booz, Allen & Hamilton.

Since banks are looking to squeeze out every last penny of profits, they are eager to shrink or shed marginal businesses. That encourages managers to bolster their departments' profits, either by raising charges for services and funds they provide or by demanding competitive prices for services and funds they purchase.

Although internal pricing discrepancies rarely show up on a bank's bottom line, they can alter the profitability of departments that sell or buy services from other parts of the bank. These intrabank results can ultimately influence the strategic focus of the whole institution.

"To some extent, it's a microcosm of intrabank politics," said a senior official at a money-center bank. "It does not affect what we report to the world, but it has some impact internally on peoples' P&Ls and bragging rights."

Going Down the Street

Like one Citicorp executive, a growing number of bankers are looking outside their own banks for funds and services.

Accustomed to financing swaps and other funding arrangements with other parts of Citicorp, this executive rarely questioned the prices he paid - until he found out that his swaps were sometimes priced 25 basis points above Citicorp's offsetting market transactions. In an arm's-length transaction, the normal spread is only 3 or 4 basis points.

These days he checks market rates before he calls other parts of Citicorp for quotes.

"We know exactly what we could do if we went outside to Morgan or Bankers Trust," he said. "The inefficiencies have been wrung out of the system."

Bargaining Room

Similar situations are developing at other banks, according to Mr. Lelogeais. Increasingly, bankers are starting to shop outside their banks to determine prevailing price levels, and then demand that internal funds providers match those prices, he said.

"Clearly in today's environment, looking at the cost side is even more critical," he said. "You try to exert pressure to get better service at a lower cost."

Squabbles sometimes erupt at banks with proven systems for pricing, according to a senior official in the treasury department of his bank. Traders are especially noisy when it comes to the cost of funding their fluid positions, he said.

But a bank's cost of funds is a blend of the rates it must pay for long-term securities as well as for overnight funding, the banker said.

The Cost of Liquidity

"Trading groups sometimes say they could fund more cheaply by going to the market," the banker said. "But every trader cannot be funded at the marginal cost of liabilities. We need to raise a prudent amount of liquidity" for the bank as a whole, and raising that liquidity raises the bank's average cost of funds above the marginal cost of overnight funding, he said.

Besides producing upheaval, installing a market-based system can produce some surprising insights into funding activities. Bankers at one midsize bank were convinced that large corporate and international lending departments were generating two-thirds of the bank's profits, said John Dorman, president of Treasury Services Corp., a consulting firm.

But the profits departments report incorporate the low cost of overnight funding, the cheapest available. Once the treasury started assigning a more realistic cost of funds that matched maturities of loans the bank was making, the picture changed. All of a sudden, the money-making departments turned out to be money losers.

Similarly, Richard Robertson, assistant to the president at Valley National Corp., said his bank installed a new transfer pricing system nearly two years ago. Since then, Valley's branch network has started to look a lot more profitable. "It used to be a cost center because it cost so much money to manage deposit accounts," he said. "Now [the branches] look profitable because they get credit for their low cost of funds" that the bank can use for other businesses.

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