Apply Transfer Pricing Rules

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- What can you tell about the relative performance of the two branches by looking at Exhibit 5?

In Exhibit 5 Caja Espana Bank used traditional financial accounting to measure the performance for each branch. Clearly we can see the difference in profitability for each branch, the Madrid-Barrio branch ended year 2002 with €571,000 in profit comparing to losses of €105,500 for Gradefes Branch for the same period. Both branches have a similar total balance of funds, 31,000 and 27,500 for Madrid-Barrio Branch and Gradefes Branch respectively. The difference in diversification of assets and liability resulted in a huge discrepancy in performance; this can be due to difference in geographical location amongst the branches. This geographical difference, lends itself to different market segments for each branch. Madrid-Barrio which is located a more commercially urban location thus explains the high rate of mortgages and credit lines in their balance sheets which totaled 15,000,000 and 10,000,000 respectively. On the other hand, Gradefes Branch is located in a rural area, which resulted in a high checking account and term deposits on their balance sheet in comparison to the low mortgages and credit lines the bank has on the balance sheet. Another aspect of these differences is the number of clients each branch has, with 1621 clients at the Gradefes branch earned 17,000 in fees in comparison with 513 clients at Madrid-Barrio with 54,000 of revenue from fees.

What can you tell from your response to question 1A? Which one is a better measure of value creation to Caja Espana? Why?

Clearly, by using the adjustment rate method and using the treasury as a bank for the branch, we can have a better measurement of performance and value creation. The bank’s operations not only include just lending money and selling mortgages and providing lines of credit, but also opening checking accounts and term deposits. Each of these operations should be rewarded and valued as part of the value creation component. By using the traditional accounting to measure the performance for each branch in terms of interests revenue and interest expenses paid to customer, our calculation does not include the contribution this branch has on creating value on the bank as a whole. For example, by taking the total amount of money that Gradefes branch has raised as of today through checking and term deposits, 25,000,000, and subtracting from them the amount of money this branch has lent to its customers which is 7,500,000 (mortgages + credit lines + cash) we end up with 17,500,000. The other branches used this money to lend its customers and didn’t give the original branch credit for raising these funds. But when using the adjustment rate and the treasury, we can mark up these 17,500,000 and reward the original branch while also creating a transfer price for these funds between the branches.

- Caja Espana wants to make its branches profit centers. Why do they want to do this? (Consider what type of actions would a manager be motivated to undertake if branches were judged for financial statements like mentioned in Exhibit 5)

If you analyze Exhibit 5, the average customer rate that the bank gets on mortgages and credit lines are 4.06% and 2.64% percentage respectively and these will be part of the interest revenues on the income statement. However, if you look at the Checking Accounts and Term Deposits interest rates, they are about 0.1% and 1.85%. These are represented on the income statement as Interest expenses as banks will have to pay customers for the amount they have deposited in the bank. If the branches were judged on financial statements mentioned in Exhibit 5 then all the bank branches will have more incentive to sell mortgages and credit lines as they will make more money and they will be doing limited transactions of checking accounts and term deposits. More incentives to just selling Mortgages and credit lines might also result in bank branches giving loans to non-credit customers. Branches will accept the clients as more as possible without taking their credibility into consideration. Also the total money that the branch raises through Checking accounts and term deposits might reduce and this might have a huge impact on the treasury because the treasury’s’ common pool amount is raised through investing the checking account and term deposits money in different markets.

But however if we treat each bank branch as a profit center and involve the treasury and use adjustment rates, then the transfer prices will come into affect and the bank branches will have more incentive to increase the deposits as well as sell more mortgages to credit worthy customers.

For Example: The financial margin is based on the calculation below:

Financial Margin

= ITDY-ICDY

= ICLX-ITLX

Based on the information in the Question 1, the checking account is most profitable (margin=4.01%-0.1%). Thus, the branches may try their best to attract customers to deposit money in the branch. Also, because the ITLX is based on the condition of loan and the risk element of the client, loans with good quality customers will require lesser payment to the pool of funds and therefore bring in better return to the branches. In this way, branches may have more motivation and incentive to do a rigorous credibility check on the customers. Thus, turning branches into profit centers will make sure that each branch will create a good balance between raising funds and lending money and will make sure that the treasury will have enough common stock to lend money. Also, turning branches into profit centers will help Caja Espana analyze how each branch is adding value as a whole. Turning branches into profit centers will give more power to the individual branch managers to apply their own strategy and own initiatives as they are aware of the local market really well when compared to the corporate. Also, it will allow Caja Espana to evaluate all the bank branches at a level field and this way they will clearly know which branches are doing well and can award more benefits to that branch and push the other branches which are not doing well to achieve the results.

- Should the adjustment rates be updated monthly or only at the time new products are sold? What would you recommend that they do? Why?

Adjustment rates should be updated monthly because it is important that the bank and managers both stay aware of the fluctuating market rates and stay informed on how the interest rates are changing and how that is affecting the