We all received the same lecture on the first day of banking school, and it started with the professor writing three large letters on the freshly-cleaned blackboard: C. O. F.
For good reason. Without a sharp eye on cost of funds (COF), banks and credit unions can expose themselves to interest rate risk (among many other pitfalls), with likely detrimental long-term effects. If the 2008 financial crisis taught us anything, it’s that net interest margins can compress quickly — and stay compressed much longer than anyone expects, or most models predict. These periods of margin compression revealed how little control we have over our return on earning assets versus market forces. That said, there remains significant opportunity on the deposit side that will ultimately enable greater control of that critical margin.
COF will always fall short when assessing the true cost for banks’ or credit unions’ most common deposit products: checking accounts.
To illustrate, a group of qualification-based, high-interest checking accounts at one of our institutions has a median of $8.57 in monthly interest expense or a COF of 0.81%. That’s high enough to send any CFO running the opposite direction. But those same accounts generate a median of $10.07 in monthly net non-interest income (NII). A complete examination reveals these accounts generate $33.16 in median marginal profit per account (monthly).
Clearly, basing strategic funding decisions on COF alone is painting an inaccurate picture.
A New Acronym
Cost of funds works well for deposit products like savings, money markets, and CDs because there’s little non-interest expense or income in these accounts. As we just saw, the same isn't true for transaction accounts. COF only accurately accounts for the interest-expense associated with those accounts. However, those same accounts also have non-interest expenses and generate non-interest income, which is easily buried in the balance sheet and not properly associated with these deposits.
Consider a free checking account; while it has a 0% cost of funds, there are a number of marginal expenses that must be considered — processing checks, sending statements (especially if they’re paper), core fees — along with whatever club account features or free toasters you may add in an attempt to differentiate. But there are also sources of non-interest income, mostly debit card interchange and overdraft revenue. When you look at this whole picture — interest expense, non-interest expense, and non-interest revenue — you are now looking beyond COF, and seeing a holistic view of the under-reported (and grossly under-utilized) metric referred to as Cost of Deposits (COD).
Cost of deposits = (non-interest income) - (interest expense + non-interest expense)
A lot of revenue and expense flows through non-interest-bearing checking accounts that never impacts the 0% COF. Reliance on COF means many institutions lack visibility into these numbers because most (if not all) of these sources are reported and tracked en masse across the entire deposit suite. This makes it virtually impossible to assign marginal expenses and revenues to individual product types, and can ultimately lead to poor strategic decisions.
Do Better Than Cost Of Funds
Transaction accounts are relatively new compared to the long history of banking. Overdraft and interchange revenues are even newer. Accurately measuring these factors into cost of deposits just hasn’t become mainstream.
The current Fed funds rate appears to be on a steady upward trajectory. This leaves many community financial institutions facing a margin compression — the result of understandable hesitancy to adjust loans rates up for fear of losing business, while deposit products are commanding higher rates.
Traditional responses to this type of compression won't work:
- Increase loan rates – The competitive loan market makes this next to impossible, except for institutions who find ways to compete on something other than rate.
- Decrease deposit rates – While many financial institutions have left their deposit rates untouched from historic lows, this is postponing the inevitable. As the Fed funds rate rises, it will eventually force upward repricing of all deposits.
- Decrease non-interest expense – Cost-cutting is likely to handicap growth.
- Increase non-interest revenue – Traditionally, this has meant new and higher fees or other strategies that draw intense consumer ire. But it doesn’t have to be that way.
If we continue looking through COF blinders, the only conclusion is to raise loan rates and hope that your competition quickly follows suit. That’s clearly not a desirable or winning strategy while loan demand remains less than aggressive.
To learn how adopting cost of deposits can position your institution for growth, download my free whitepaper.