Introduction
The method by which financial institutions determine the cost of funding new loans is a critical component of their profitability and long-term stability. While some institutions rely on the average cost of funds—a measure that includes historical deposit costs such as certificates of deposit (CDs) originated in the past—this approach has significant drawbacks in aligning loan pricing with current market conditions.
The alternative, using marginal or market-aligned funding costs, such as those derived from Funds Transfer Pricing (FTP) systems, is widely recognized as a best practice for ensuring accurate risk-adjusted pricing and profitability measurement. This paper examines the challenges and implications of using the average cost of funds as an internal measure, contrasting it with the benefits of a market-sensitive approach. By exploring regulatory guidance, industry practices, and practical outcomes, this discussion highlights why average cost-based methodologies often fall short in today’s dynamic economic environment.
1. Mismatched Time Horizons:
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- The average cost of funds includes historical deposit costs, which do not reflect the current or marginal cost of raising funds for new loans.
- Impact: If deposit rates have risen, relying on a historically lower average cost can underprice loans, leading to profitability erosion.
Evidence: The Federal Reserve and industry literature emphasize the importance of aligning funding costs with current market conditions, as historical averages may misrepresent the opportunity cost of capital.
2. Lack of Market Sensitivity:
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- Loan pricing based on the average cost of funds ignores current market dynamics, such as changes in interest rates or liquidity spreads.
- Impact: This can result in mispricing relative to competitors who use market-aligned metrics like FTP or marginal cost of funds.
Example: A 2022 study by the Bank for International Settlements (BIS) notes that average cost-based pricing leads to strategic vulnerabilities in volatile rate environments.
3. Distorted Profitability Metrics:
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- Using the average cost of funds may artificially inflate apparent profitability on loans when historical funding costs are low, or understate it when costs have risen.
- Impact: Misalignment of profitability metrics can lead to poor capital allocation and reduced return on equity (ROE).
Evidence: Academic research (e.g., papers on ALM best practices) highlights that average-cost-based methods obscure true profitability by failing to capture the marginal economic contribution of loans.
4. Incentivizes Suboptimal Behavior:
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- Business units may pursue growth aggressively, pricing loans at rates that do not adequately compensate for the marginal cost of new funding.
- Impact: This can result in funding strains, liquidity mismatches, or misaligned growth objectives.
Example: Real-world bank failures, such as those stemming from misaligned funding and asset strategies, underscore the risks of using outdated cost measures.
Comparison to Marginal Cost of Funds or FTP
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- Using FTP or marginal cost of funds ensures that:
- Loan pricing reflects the current cost of raising funds, including factors like liquidity premiums and market spreads.
- Interest rate risk and funding mismatches are minimized.
- Loan pricing is competitive and sustainable across economic cycles.
Counterarguments for Using Average Cost of Funds
1. Simplicity:
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- Proponents argue that using the average cost of funds simplifies internal calculations and avoids the complexity of FTP systems.
- Rebuttal: While simpler, this approach sacrifices accuracy and long-term stability, leading to strategic mispricing.
2. Perceived Stability:
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- Average cost smooths volatility, which can be appealing in environments with fluctuating rates.
- Rebuttal: This stability is artificial and fails to reflect the economic realities of funding new loans.
Regulatory and Academic Best-Practice Guidance
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- Regulators, such as the Federal Reserve and OCC, and industry leaders discourage reliance on historical averages for strategic decision-making. Read the March 2016 Interagency Directive on Funds Transfer Pricing.
- NCUA is actively discouraging reliance on historical averages for strategic decision-making.
- An example of academic papers on using FTP. Journal of Financial Perspectives, Vol. 1, No. 1, 2013
- Instead, they advocate for approaches like FTP, marginal cost, or market-aligned benchmarks (e.g., SOFR + liquidity premium).
In summary, using the average cost of funds to price new loans is generally not considered appropriate because it ignores current funding realities and leads to mispricing risks. While it may be simpler, it undermines strategic alignment and profitability.