Many credit unions continue to use their internal cost of funds rate as the implied funding rate for new lending activities. On the surface that sounds reasonable, but after just a little bit of deeper thinking that mindset doesn’t make a lot of sense. Compounding the issue, while interest rates were low and very stable it was easy to get away with historical cost pricing. Later we will expose the problem with this concept in the context of rising interest rates.
First, consider what the cost of funds is. It is the weighted average of all the funds put on the books over the last few years. As interest rates have risen recently, it is a historical average rate that bears little resemblance to current market rates.
With that understanding, here are just a few flaws with the historical cost of funds funding concept:
- New money cannot be obtained today at historical rates.
- All existing funds are already used to fund the outstanding loans. Money cannot be used twice. New money is required to fund new loans.
- Interest expense is only part of the funding equation. There are also servicing costs as well as revenues from debit card interchange and punitive fees that impact the true cost of funding new loans.
- Shares often generate more revenue than the cost to service and are a net profitability contributor. It is proven that deposits commonly make money for credit unions, often greater than loans. Ignoring this reality can lead to incorrect pricing decisions.
- There is also a hidden danger in using the internal cost of funds in a rising rate environment. Using a historical cost of funds measure will make it appear that you can profitably lend at below current market rates. Determining the funding cost from rates only available months ago results in initial margin growth. However, as the internal cost of funds catches up with the market the margin can whipsaw and crater.
Another interesting concept is as rates rise new loans come on the books at ever increasing yields. However, because most credit unions are heavy in administered rate core deposits the internal cost of funds likely goes up slower. So, did the assets create the increased margin or was it the controllable deposit costs?
The winner, hands down, are the deposits as it’s hard to argue that things beyond your control can consistently create more value than controlled items. You can control your loan rates to some extent, but only down below market, not up above market unless you don’t want to be competitive.
The change to marginal cost pricing, where the cost of new money is used to price new loans, will likely make your lending team uneasy. That’s understandable as this new thinking will bring into question their long history of using historical cost pricing. To address some of this resistance developing a common basis for understanding is quite valuable. Here are some questions to ask your lending team:
- Question: Why don’t you use the current portfolio average yield to price NEW loans?
- Answer: They will say that’s ridiculous because it doesn’t reflect the current market for NEW loans.
- Question: Why don’t we use the current cost of funds to price NEW deposits?
- Answer: Again, the response will be that’s absurd because it doesn’t reflect the current market for NEW deposits.
- Question: So why should we use the average historical cost of OLD deposits to fund NEW loans? Given the first two answers does that make sense?
- Answer: The most common response is “Oh, that does not make a lot of sense”.
The organization is now aware of the importance of marginal cost pricing. At this point, you have gained a common level of understanding that should make the adoption of Funds Transfer Pricing more palatable. Funds Transfer Pricing is the formalization of marginal cost pricing. For more information on how to implement Funds Transfer Pricing at your institution visit Kohl Analytics Group – Funds Transfer Pricing page.