Zeroing in on the Cost of Funds

By Chris Bledsoe

In the April 2008 edition of Directors Digest we discussed the significance of tracking the trend and drivers of the bank’s net interest margin – the single, greatest source behind 90 percent of a community bank’s earnings stream. There are two major components of the margin that a bank can control, earning asset yield and the cost of funds. This month, we are zeroing in on cost of funds to give you greater insight into how you can help the bank answer a critical question: How can we fund our earning assets with the lowest cost of funds available?

What is the Cost of Funds
Cost of funds is simply, the interest cost that a financial institution must pay for the use of money. It’s important to understand exactly what makes up the cost of funds because there are a couple of different approaches utilized in the market. For purposes of this article, cost of funds is calculated as follows: total interest expense, annualized/ divided by average interest bearing deposits and other interest bearing borrowings, plus average non-interest bearing checking deposits. It doesn’t include the impact of capital (which assumes a zero cost), although some will include capital in a “cost to fund earning assets” calculation.

Track the bank’s trend in cost of funds and isolate opportunities to improve the overall health of the bank.

Know the Impact of Each Component

It’s important to break down and analyze each component that contributes to the cost of funds in order to understand its impact. Ideally, the bank should have its general ledger structure set-up to easily track the balance and interest expense on each deposit/borrowing category. This will make analyzing the variances in the different deposit categories, from a yield and rate standpoint, much easier.

Cost of Deposits – There are two areas to track: 

Interest bearing demand deposits – This is a very important area because it’s one the bank can directly influence. It includes interest bearing IOLTA accounts (where attorneys park their escrow money), savings accounts, and money market accounts.

Time deposits – Break this into two areas: time deposits-retail (CDs and IRAs); and, time deposits-wholesale (brokered and non-brokered wholesale CDs, including internet CDs).

Cost of Borrowings – Borrowings include: Federal funds purchased; repurchase agreements; advances from the FHLB; loans from correspondent banks; and, other sources such as commercial paper sales.

Maturities – The bank should be laddering time deposit maturities similar to what many banks do on the investment security side. This is important because you want to ensure the bank is using wholesale funds (the wholesale CDs we mentioned or wholesale time deposits, federal home loan advances or other interest bearing deposits) to its advantage in order to supplement what the bank’s doing on the retail side. You don’t want big spikes to occur in your maturity distribution; laddering helps to spot any potential issues.

The Mix – Understand how your deposit mix has changed from a year ago and how it compares to prior periods and budget. You’ll need to evaluate this component on an overall and branch-by-branch basis; the mix can greatly vary your overall cost of funds.

Get Answers to Your Questions
Following are a few questions you can ask that will help direct the bank to better manage its cost of funds:

• What is the trend in the cost of funds over the past twelve months? In the different categories? How does each category compare to budget?
• How has the mix changed compared to prior periods? Compared to a year ago? 
• How does the cost of funds vary branch-to-branch? What is the mix in each branch?
• Where are the cheapest deposits located? What can be done to increase deposit growth in those areas?
• What is the bank doing every day to generate more non-interest bearing checking and interest bearing demand deposits? Are employees asking for them?

Cost of Funds – A Focus for High Performers
Cost of funds is one of two major drivers of the net interest margin and is therefore, a primary focus for high performing banks. Recently, high performing banks have been placing more emphasis on generating non-interest bearing checking and interest bearing demand deposits, to the degree that they’re designing incentive programs singularly based on that. Why? Because they know that this is one area that has the biggest impact on the cost of funds and ultimately, the overall health of the bank.

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