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The Impending Transfer Pricing Crash

The profitability of non-credit businesses – like cash management – relies heavily on deposit spread. Small business clients receive a wealth of operating services without fees by holding sufficient balances. Middle market and large corporates offset fees with balances, which earn short-term interest credit (ECR). In a normal rate environment, these compensation schemes are highly valuable to banks. They produce a stable core of relatively price insensitive deposits that are valued as a mix of short-term and long-term funding. But let’s look at what happens to the profitability of these businesses under the current abnormal conditions – or worse.

The above data is drawn from a benchmark analysis of the treasury management P&L of 13 regional and global banks. See notes, below, for greater detail on data sources and analysis.

As can be seen above, the profitability of the cash management business is predicated on deposit spread. In a normal interest rate environment, the business produces a fully loaded pre-tax profit of 49%.

Returns are still attractive at current depressed rates, with margin declining to 40%. While this is below bank investor expectations, it is still highly attractive because the cash management business does not require capital. (In contrast, the credit business can produce pre-tax margins of 80 to 85%, but is a significant consumer of capital).

Projecting rates into the future, we see the recent decline in long-term rates will have a massive impact on transfer prices. With the 5-year (rolling average) swap rate falling to 1.50%, spread revenues are cut in half relative to current levels, and total revenues decline over 30%. Pre-tax margin falls to 26%.

Under a marginal valuation, profits drop further. Most banks now hold substantial excess reserves at the Fed, earning 25 bps. If commercial deposits were valued at this marginal value, the P&L would be nearly destroyed. Profits would plummet 90% from “normal” levels, to a weak pre-tax margin of 9%.

These scenarios apply to analyzed deposits. The situation for non-analyzed (small business) deposits is even worse, which is due to limited recovery of FDIC charges. Fixed balance compensation schemes also impact deposits in the small business segment where ECR declines as short-term rates decline.

In our next post, we’ll look at how Money Market Mutual Fund reform proposals could exacerbate the impact of the current economic environment – and we’ll then review what banks should be doing to mitigate these challenges.

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Fees were indexed to 100 and other revenue and expense were expressed as a percentage of fees. Spread revenues were calculated by adjusting the transfer price, assuming a mix of 80% rolling 5-year swap rate and 20% 90-day LIBOR.

  • All data taken from the Federal Reserve statistical register
  • The normal environment reflects a 10+ year average (July 2000 through November 2011)
  • The current environment reflects 90-day LIBOR as of November 2011 and the rolling 5-year swap rate average (December 2006-November 2011)
  • The future environment was derived from an exponential trend analysis
  • The marginal environment represents a scenario in which bank Finance / Treasury reduces the value of deposits to 25 basis points to reflect the inability to reinvest deposits at a marginal rate above that provided by the Central Bank. Given the FDIC premium on assets, the marginal benefit of these balances would actually represent 25 basis points less the FDIC insurance premium).
  • Indexed expenses of 97 (e.g., 97% of fees) is comprised of: Professional Staff (23); Technology (18); Operations (44); and Other / Overhead (12).
Dave Robertson


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