Assessing Your Institution’s True Cost of Funds: Applying a Marginal Cost Framework to Your Decision Making

May 2012

Like many others, your institution has likely experienced record deposit growth over the past few years. While a lack of attractive opportunities in which to invest this low-cost source of capital is less than ideal, deposit growth has been widely viewed as a source of strength. But as the old saying goes, all good things must come to an end. Whether it is an end to the Transaction Account Guarantee program, a re-allocation of deposit dollars, or both, most would agree that institutions will ultimately come under pressure to retain existing deposits or replace those that are lost with other sources of funding.

The million dollar question is, when will this pressure materialize? When it does, how will you assess your cost of funds—the amount you pay for deposits as compared to the cost of wholesale funding?

The Seattle Bank has developed a tool that can help you assess your true cost of funds. We call it Marginal Cost of Funds Analytics. As the name suggests, it is designed to help you quantify the marginal cost of deposit growth and/or retention strategies compared to the use of Seattle Bank advances. When we say marginal cost, what do we mean? One definition of marginal cost is the change in total cost that arises when the quantity produced changes by one unit. In this case, the units are deposits. As the following examples demonstrate, assessing the true marginal cost of raising new or retaining existing deposits can be difficult and often results in a different outcome than one might expect.

Whether creating a new account type for a niche market or simply responding in lockstep with your competitors’ rate increases, it’s important to understand your marginal cost of funds to avoid overpaying for deposits through cannibalization of your existing accounts or overpaying for deposits that you were never in danger of losing! To do so, you need a quantitative framework for evaluating the relative attractiveness of your various funding options.

Consider a scenario in which your institution is contemplating a strategy to raise new deposits. The plan is to offer a promotional rate on a one-year certificate of deposit (CD) in an effort to raise $5 million. To assess the marginal cost of this strategy, you have to estimate the value of four variables:

  1. Promotional Rate: The rate you are going to pay on the new promotional account.
  2. Cannibalization Rate: The proportion of existing accounts that will transfer to the new promotional account.
  3. Current Rate on Re-priced Accounts: The weighted average rate on existing accounts that will transfer to the new promotional account (reflects the cannibalization that occurs).
  4. Seattle Bank Advance Rate: The rate on an advance of similar tenor to the new promotional account.

Of the four variables, the cannibalization rate and the current rate on re-priced accounts are the most difficult to estimate and can have a significant impact on the results of the analysis. Let’s take a look at two of these variables a little more closely. Let’s assume that when you launch the new promotional CD that, in addition to attracting new funds, 4.5% of your existing depositors will transfer their funds to the new account in order to take advantage of the higher rate. This is your cannibalization rate. When considering your institution’s cannibalization rate, it is important to note that the interest rate sensitivities of your existing deposit accounts are subject to the unique characteristics of each market and should be analyzed over multiple credit cycles. Table 1 illustrates the existing deposit profile of a typical institution, the relative proportion of each deposit type expected to transfer to the new account, and the current rate on each account. In this example, .39% represents the weighted average rate of all existing deposit accounts that are expected to transfer to the promotional account. In other words, $4.5 million of existing deposits with a weighted average rate of .39% are expected to re-price.

Table 1. Hypothetical Existing Deposit Base and Relative Proportions of Transferred Deposits

Type of Account Amount Current Rate Transferred Balance % Transferred* Transferred Interest
Non-Interest Checking 8,987,385 0.00% 225,000 5.00% 0
Interest Checking 3,723,510 0.20% 225,000 5.00% 457
MMDAs 66,968,486 0.45% 2,925,000 65.00% 13,163
Other Savings 5,872,179 0.13% 450,000 10.00% 585
Time Deposits < $100k 7,016,503 0.75% 225,000 5.00% 1,688
Time Deposits >=100k 7,431,937 0.35% 450,000 10.00% 1,575
Totals 100,000,000 0.40% 4,500,000 100% 17,467
Weighted Average Rate of Shifted Money 0.39%

*Assuming cannibalization rate of $4.5% on $100 million, or $4.5 million.

Assuming a 4.5% cannibalization rate and 0.39% rate on re-priced accounts, Table 2 shows the marginal cost of attracting $5 million in new one-year deposits with a promotional rate of .55%, exposing the hidden costs of this strategy. Although we were able to raise $5 million in new deposits, cheaper existing deposits were also cannibalized.

Table 2. Marginal Cost of Promotional Strategy

Source of Funds Amount Current Rate New Rate Rate Increase Marginal Cost
Cannibalized Deposits 4,500,000 0.39% 0.55% 0.16% 7,200
New Deposits 5,000,000 0.00% 0.55% 0.55% 27,500
Total $9,500,000 $34,700
Marginal Cost 0.69%

Under these assumptions, the true cost of raising $5 million in new deposits is actually $34,700 or .69%. Mathematically, this is the increase in total cost ($34,700) divided by the change in total deposits ($5 million). Given the marginal cost of a one-year Seattle Bank advance is .59%, a call to the Funding Desk may be in order! While these assumptions may not be representative of your institution, the Seattle Bank’s Marginal Cost of Funds Analytics affords you the flexibility to change these assumptions and see the resulting impacts as you see fit.

Shifting gears for a moment, let’s assume the competitive landscape is much different than today’s. In lieu of being flush with deposits, consider an environment where deposits are more transient and the focus is on maintaining existing capital levels versus growing deposits. Perhaps your competitors are increasing rates on one-year CDs and you need to evaluate whether or not to respond in lockstep. In this type of analysis, you need to estimate the percentage of your institution’s maturing one-year time-deposit accounts that will move to the competition unless you match the competition’s rate. This percentage is defined as the rate-sensitive portion of that segment of the deposit base. Table 3 shows the rate-sensitive and non-rate sensitive portions of the maturing one-year CD accounts for our hypothetical institution. Here we assume 45% of the account holders are rate sensitive and that 50% of existing balances are maturing in a short period of time.

Table 3. Rate-Sensitive and Non-Rate Sensitive Portions of Maturing One-Year CD Accounts

Deposit Type Amount Rate* Cost
Non-Rate Sensitive 3,973,321 0.40% 15,893
Rate Sensitive 3,250,899 0.40% 13,004
Total $7,224,220 0.40% $28,897

*The rate paid on existing time deposit balances from Table1 that are maturing in a short period of time.

Let’s assume that we raise rates in order to retain the maturing deposits. Table 4 shows the marginal cost of the “pay-up” strategy.

Table 4. Marginal Cost of Increasing Rates to Retain Deposits

Deposit Type Amount Current Rate New Rate Rate Increase Marginal Cost
Non-Rate Sensitive 3,973,321 0.40% 0.55% 0.15% 5,960
Rate Sensitive 3,250,899 0.40% 0.55% 0.15% 4,876
Totals 7,224,220 0.40% $10,836
Marginal Cost 0.33%

Alternatively, let’s assume that we hold our ground and let the “hot” money go. Table 5 shows the marginal cost of holding rates constant and replacing the runoff with a one-year Seattle Bank advance at a rate of 0.59%.

Table 5. Marginal Cost of Holding Rates Constant and Replacing Runoff with a Seattle Bank Advance

Deposit Type Amount Current Rate New Rate Rate Increase Marginal Cost
Non-Rate Sensitive 3,973,321 0.40% 0.40% 0.00% 0
Rate Sensitive 3,250,899 0.40% 0.59% 0.19% 6,177
Totals 7,224,220 0.40% $6,177
Marginal Cost 0.19%

Here we can see that, given the assumed parameters, a substantial savings can be realized by allowing the rate-sensitive deposits to runoff and replacing them with on-demand funding from the Seattle Bank.

Check out our Marginal Cost of Funds Analytics to analyze a variety of scenarios tailored for your unique circumstances. Whether you want to grow your deposits or retain your existing balances, the marginal cost of the strategies used in accomplishing your objectives should be considered. As we have seen, when the hidden and not-so-hidden marginal costs are considered, tapping the Seattle Bank’s reliable wholesale funding may be the cheapest alternative.

Mike Terry, is the Business Development and Funding Desk Analyst at the Federal Home Loan Bank of Seattle.

Brett L.A. Manning, CFA, is the National Sales & Funding Desk Manager at the Federal Home Loan Bank of Seattle.

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