There are many different methods for calculating profitability in a financial institution. Traditionally, the focus has been on calculating profit for an account or customer relationship using sources and uses of a customer’s funds. These methods usually look at the spread between the interest paid on deposits and the interest paid on loans as well as other fees and expenses.
These traditional methods do not give adequate credit to low cost or no cost deposits. Most banks are transitioning to Funds Transfer Pricing as the primary mechanism for calculating profit to increase the accuracy of their profitability calculations.
Funds Transfer Pricing is basically a way to allocate interest income into components on both sides of the balance sheet. FI Works supports a number of Funds Transfer Pricing methods.
The most popular choice is to use a single flat rate method that uses the average of the rate on new and renewed CDs and new and renewed loans. FI Works uses this rate to calculate the earnings credit and cost of funds.
Profitability is calculated at the individual account level using the following formula:
Profit = Interest Income – Interest Expense + Fee Income – Administrative Costs – Transaction Costs + Earnings Credit – Cost of Funds
Interest Income, Interest Expense, and Fee Income
Interest Income, Interest Expense, and Fee Income are taken directly from the core banking system. Interest amounts represent accrued interest rather than interest paid.
Administrative Costs
Administrative costs are allocated expenses that reflect the marginal cost of an account. For example, for demand deposit accounts, this may include debit card expenses or the cost of data processing per account. For loans, marginal costs may include loan loss reserve expense and origination expenses.
Transaction Costs
Transaction costs also represent marginal allocated expenses. However, these expenses are calculated based on customer transactions. Transaction costs could include costs for wire transfers or other transaction level expenses.
Earnings Credit
FI Works calculates the average rate for last month’s new and renewed CDs as well as the new and renewed loans. This rate is applied to the balances of each deposit account on a daily basis.
Cost of Funds
The same rate is applied to the balances of each loan account on a daily basis.
Reporting
FI Works performs all of these calculations for each account for every time period processed. This granular level of data allows the reporting components of the system to aggregate the result into any view desired by the end user. For example, reporting on profitability by product category is as simple as adding the profit from each account type into the appropriate product group. Similar summations are done to report on profitability by branch, officer, geographic region, customer segment, and individual customers.