TRANSFER PRICE MECHANISM

The prime motto of any business organization is to earn profit, which is necessary for survival of any institution. Continuous losses are drag on any institution which forces it to a dead end. Profitability is the lone important factor for determining efficiency.

The banking industry which has the responsibility of economic development has itself to be healthy first, then only the health can act as contagion, and for good health profitability is the only barometer.

Liberalisation, Privatisation and Globalisation (LPG) has increased competition and created a demand for higher efficiency in the banks. Information Technology has narrowed territorial distances and brought the world closer. It has also increased customer awareness and has made him demanding. Competition has narrowed the margins, which are shrinking day by day. Non-Performing assets have added insult to the injury.

Under such a situation profitability of bank and viability of branches is the main cause of concern for the industry. The question is, can loss making branches turn around, are these branches really unviable and are threat to viable and profitable branches. Are these branches siphoning profits of bank? Hence, proper assessment of profitability of branches and profits earned is must. There is no systematic and scientific tool to differentiate between a loss making branch and an unviable branch.

Need for Transfer Price Mechanism: -

The branches of banks are spread in different geographical and economic areas having different business and earning potentiality .The level playing field is not the same. At some centres there may not be much economic activity and earning avenues due to no scope of lending. But there may be scope and potentials for deposits i.e., resource mobilisation. The situation can just be reverse at another centre. Hence, at one centre bank’s earning may be more due to its advances portfolio and at the other centre it may be just the reverse as the centre has only deposit potentials. Though bank needs both i.e. resources and its deployment. Hence a compensatory receipt and payment system has to be followed which would reflect true and fair picture of branch profits and its efficiency. This mechanism is known as “ Transfer Price Mechanism”.

What is Transfer Price Mechanism:

Theoretically transfer price mechanism is aimed at measuring profit contribution of various divisions and to facilitate evaluation of their relative performance. Transfer prices are cost based. Ideally, it should be negotiated between the transferring and receiving units, which are independent. However, since bank branches enjoy only limited operational freedom, the head office not only plays the role of intermediary but also of ultimate authority or body for deciding the price keeping in view the overall cost and income. Transfer price mechanism is an internal measurement designed to assess the financial impact of uses and sources of funds and can be used to evaluate the profitability.it can also be used to isolate returns for various risks assumed in the intermediation process. It also helps in identifying the cost of opportunity value of funds.

Objectives of Transfer Price Mechanism

· To evaluate the true profit and operational efficiency of branches.
· To adequately compensate both deposit mobilising & deploying branches
· To effect equitable distribution of profit
· To deliver stable source of funding over time.

How the system operates ?

The resources mobilised by the branches are treated as the funds lent by them to head office and the advances given by them as funds borrowed from Head office. Price for both these transactions are fixed. Different banks follow different system .at present following systems are followed.

1. Unitary System: -

Under this system of Transfer Price Mechanism only one single rate is applied to head office balance in the books irrespective of the fact that such balances are Debit or in Credit .It is the simplest system

Demerits of the system:

· The system does not reflect correct measurements of performance of funds providers and users.
· Since interest paid on deposits are less than the interest charged on advances, the branches with heavy advances portfolio will show high profits than the deposit oriented branches

2. D ual System: -

Under Dual Transfer Price Mechanism there are two different rates one for lending to head office and the other for borrowings from Head office.

Demerits of the System:

· The branches having significant portfolio of Current Deposits show high profits as no interest is paid by them on such deposits but they get interest on these deposits from Head office. This does not reflect true picture of profit.
· Branches having heavy portfolio of Term Deposits will show lesser profit as rate of interest paid by them on term deposits are high. Branches saddled with heavy portfolio of term deposits generally do not show good performance.
· Branches with substantial advances portfolio will not reflect true picture of their profits as they will get only predetermined rate whereas they may have advances in different rate buckets and even some advances may be below Prime Lending Rate.( In this competitive era where the advances are increasing at a slow pace , banks are flushed with funds and the big corporate clients have option to tap resources from open market banks are lending at far lower rate than their Prime Lending Rate. )
· In Rural branches deposits are mainly kept in the form of Savings deposits or Term deposits. These branches lend at comparatively lower rates. As these branches do not get matching rates on Debit /Credit balances from Head office there profit and loss does not show true picture under Dual Transfer Price Mechanism.
· This system does not take care the change in the interest rate structures, which are governed by the market forces.

3. Multiple Systems:

The basic premise of this Multiple Transfer Price Mechanism is that deposits and advances have equally important role in the profitability of the branch. Under this system different weightages are attached to the normal interest rates of deposits and advances

Demerits of the system

· There is no consistency in the profits of the branch. Change in any parameter may change the profitability pattern of the branch.
· The service cost at the branch level goes on changing every year and it differs from branch to branch. However, impact of the changes in service cost is not taken till it is stabilised.

Out of the three above stated systems, Multiple Transfer Price Mechanism is the best. However, in the present scenario this system also needs further modification, as this does not take care into account various international banking practices, which are being adopted by the banking industry.

Since different system can produce different transfer prices as also different prices can be worked out in the same system, it appears to be quite possible for a bank to convert its loss making branches into profit making branches or vice versa by changing transfer prices thereby enforcing substantial quantitative variation in the measurement of profit and loss of the branches.

There is no uniform practice followed by the banks in India for Transfer Price Mechanism. Therefore, the number of branches showing profit / loss by individual bank in the same economic / geographic region cannot be compared. Hence there is a need for Uniform Transfer Price Mechanism.

Reserve Bank of India has advised banks to move towards Matched Funds Transfer Pricing [MFTP] in a phased manner. Under this system, transfer price will be related to market rate. Branches will be given incentives in the form of HO interest to the extent of difference in the rate offered by the branch for a specific assets or liability and market rate for assets or liability of similar maturity which is opportunity cost of assets or liability. Market rate may be higher or lower than the rate at which branch mobilised deposits or created assets. It is the rate at which alternate resource or deployment opportunities are available ion the market.

Matched Funds Pricing [MFP] Technique measures the margin of each transaction. The bank bases the transfer price on the instruments own specific maturity and re-pricing characteristics. The bank obtains rates from selected Yield-Curve as of the date of transaction.