Context
In many banks the branch cost of funds was calculated from a blended cost of liabilities. The flaw is that it reduces different risks to a single price: a one-year fixed-rate local currency loan and a five-year floating-rate foreign currency loan are priced off the same funding cost. The result is that some products are systematically underpriced and others overpriced. Profitability measurement then produces the wrong signal, and a branch can be incentivised to sell a product that actually loses money.
Approach
- The branch cost of funds was decomposed from a blended rate into its risk components.
- Fixed-rate products were based on TRYIBOR/LIBOR or IRS rates by maturity; floating-rate products used market rates matching their payment frequency.
- A basis curve was defined by Asset-Liability Management to manage the difference between payment frequencies.
- For foreign currency products, the country risk gap between the risk-free market rate and the bank's actual borrowing cost was managed on a separate curve.
- An additional cost component was defined for prepayable products to cover reinvestment risk.
- Price differentiation driven by marketing policy was separated out as a distinct product margin entry rather than buried inside the cost.
Outcome
- Product pricing came to reflect the real risk components it carried.
- Profitability measurement made cross-subsidy visible instead of concealing it.
- Pricing decisions driven by marketing were separated from the cost calculation and made transparent.
- Entry and monitoring of the branch cost of funds became separately manageable.
This case study describes the project through its scope and approach. Client name, commercial figures and performance metrics are withheld under confidentiality obligations.
What This Project Left Behind
A badly built internal pricing system produces a badly built strategy, because everyone behaves according to what they are measured on. If a product's true cost is unknown, the profit reported on it is meaningless. This is the most common problem encountered when building product and customer profitability analysis in companies: revenue is measured accurately, cost is allocated as an average.
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