A bank's branches raise one-year deposits at 6% and its lending unit makes three-year loans at 10%. Using the treasury's transfer pricing curve, split the 4 point margin between deposit gathering, lending and the maturity mismatch.

The branches earn 0.5 points, the lending unit 2.7 points and the treasury 0.8 points for running the maturity mismatch. On Rs 1,000 crore that is Rs 5, 27 and 8 crore a year. The treasury also carries the interest rate risk: if one-year rates rise 1.5 points at renewal, its slice turns to minus 0.7 points while the other two units are untouched.

Imagine a family business where one sibling brings in customers' money, another makes the sales, and a third decides how to fund everything. If all profit is credited to whoever makes the sale, nobody values the sibling bringing in cheap money, and nobody notices the risk the funder takes. Funds transfer pricingAn internal price at which a bank treasury buys money from deposit-raising units and sells it to lending units, set by maturity so each unit is paid for its own contribution. gives each unit a price for money by maturity, so each is paid only for what it controls.

The branches raise money at 6.0% and sell it to treasury at 6.5%: 0.5 points. The lending unit buys three-year money at 7.3% and lends at 10.0%: 2.7 points. The treasury buys at 6.5% and sells at 7.3%, earning 0.8 points for funding three-year assets with one-year money. The slices add to the 4.0 points between deposit and loan.

The treasury, and that is the point of the design. The loans are fixed for three years; the deposits reprice after one. If one-year rates rise 1.5 points at renewal, treasury must pay 8.0% for money it has already sold at 7.3%, and its slice turns from plus 0.8 to minus 0.7 points. The branches and the lending unit keep their margins, because they were paid against a curve locked on the day. The risk now sits with the one desk that can hedge it, for instance with interest rate swaps.

Say what the first pass left out. A real curve adds a liquidity premium for longer money, which raises the charge to the lending unit and pays the branches more for stable deposits. And the lending unit's 2.7 points must still cover credit losses and operating costs, so it is not all profit. The judgement for management is simple: without transfer pricing, the lending unit would report 4 points and look far better than it is, and the bank would reward it for a mismatch it does not carry.