Funds transfer pricing in Islamic banking

By Peter BokmaFunds transfer pricing, or FTP, is a mechanism whereby banks internally charges business units the utilisation of funds. The central unit providing the ‘profit rates’ (conventional term equals interest rates) for the assets and liabilities is the “asset and liability” (ALM) department within the treasury of the bank.FTP rates consist of interbank bid and interbank offer rates, plus additional margins like liquidity premium, which is the added margin a financial institution must pay to the market for obtaining funds, and risk premium that refers to asset class usually a pre-defined risk matrix that includes certain type of customer financing for example.The utilisation of FTP has different methods that can be applied, but depending to the organisation, the “match to maturity” method is the most commonly used, but “pooled” is also a very acceptable method as well. The first method means singularly measured, while the latter is the measuring per time bucket (tenors). In a nutshell, one can deduce that FTP is performance measuring of business units within the bank or organisation. FTP has also one further use, and this has to do with the steering of the cost of funds (COF), which is basically the cost of liabilities, ie, the customer deposits, term deposits, capital of the bank and so on. The steering of those rates may alter the COF profile and in turn this may add to the profitability of the financial institution, or company applying this mechanism. FTP in Islamic banking has certain challenges when applying the preferred selected method. For the purposes of this article, the Shariah view is not discussed, only the mechanistic application of FTP within an Islamic bank. From the latter perspective, the challenges mainly refer to product behaviour, for which some products do have certain characteristics conventional banking products do not have.For example, the unrestricted investment account (URIA) deposit attains an expected profit rate, which is partly reflecting current market rates and partly profit sharing of bank’s income. The ‘FTP bid rate’ containing market bid rate plus liquidity premium, does not reflect the profit sharing mechanism the URIA has. Therefore, from an Islamic banking perspective, the URIA FTP bid rate for performance measuring should contain a formula that captures the profit sharing nature, thus creating a special FTP bid rate for this product.  Also, one should note that an added issue with this product is that the expected profit rate is only allocated at the end of each profit sharing period, which could be monthly, quarterly or annually, depending on each organisation’s policies. Therefore a temporarily assigned FTP bid rate may be the solution, and final one attached at the end of each relevant period with an adjustment mechanism in place to ensure that the final profit rate (actual paid) is reflected in full year FTP measurements.From an asset product point of view, the ‘Musharaka’ is not a loan facility and does not have a fixed tenor per se. This product using the ‘FTP offer rate’ for measuring purposes would be lacking this feature as well. Adding which tenor we should be attaching to the product is the other issue we may have. The solution to this problem might be using a fixed term calculative two years period or any selected desired time period, or a benchmark (local capital markets product) and further adding the usual liquidity premium plus a formula for profit sharing to create the end result FTP Offer rate for ‘Musharaka’. Within Islamic banking, there are a number of products that resemble conventional products, like conventional leasing versus ‘Ijara’ for example. This product uses the FTP offer rate as measurement, but follows time buckets that fall in line with the FTP tenors falling in the same time buckets. Just to clarify, if we had an Ijara of 24 months, there would be 24 instalments, ie, the first instalment would be one month FTP offer; second instalment would be two months FTP offer etc.The FTP environment has solidly entered the Islamic banking environment and is being perfected whilst the challenges are being faced. The FTP tool helps the Islamic banking world to compete with the conventional banking, and the growth pattern witnessed in Islamic banking can be part contributed to a solid FTP mechanism used. The more product behaviour understanding is applied, the more Islamic banking may benefit for the future and beyond.Peter Bokma is chief of treasury and investments at International Islamic. The views expressed are his own.