Pricing Loans In Relationship To Your Bank's Cost of Funds

Cost of Funds

Banking is competitive. Luckily, community banks have a number of competitive advantages over national banks. However, if you ask the average banker, it doesn’t feel that way, particularly when it comes to loan pricing and community banks are forced to compete against 10-year, 3.90% fixed rate loans. Then again, many community bankers state that they cannot compete against the national banks because of higher cost of funding.  This seems like a downward spiral - If your cost of funding is higher, your loans must be priced higher too to reach the same NIM, and therefore, the same ROA – so the argument goes. There are two flaws with this argument: 1) loan pricing should never be influenced by a bank’s cost of funding; and, 2) community banks, in fact, have a funding cost advantage over national banks. 


Banking Is Different Than Almost Any Other Industry


Let’s think about the first argument. Some bankers say that they cannot price loans competitively because their cost of funding is too high. If this is the case, the answer is to spend more resources to reduce funding costs and better manage the liability structure. Just because a bank’s cost of funding is above average does not persuade a borrower to pay more for the loan. Further, unlike a manufacturer of widgets, bankers enjoy “future variable cost management.” This is somewhat unique in the fabric of American industry and means that while revenue is fixed, banks can actively manage expenses to achieve greater future profit. Banks all over the country are booking loans today, knowing that their input costs will come down in the future thanks to technology, risk management, liability management and a variety of other factors. In other words, just as banks look forward on credit, banks need to look forward on their cost of inputs.


Further, a bank’s funding cost and loan pricing are strategic decisions, not tactical decisions. If you choose your funding cost to be high, then your bank needs to seek out business lines that produce an excess risk-adjusted return such as credit cards. Banks that fail to make this distinction usually end up dealing with the problem on a tactical, reactive basis and get adversely selected by the marketplace. These banks either take on more risk than they want, book smaller loans or book loans for customers with low lifetime values. The result is a below average ROE.


Don’t take our word for it, try to look for a high performing bank with a high cost of funds, no market focus and a long term above average return – you can’t find one. Ultimately, higher cost of funding at a bank may dictate a sale, a merger or abandonment of a charter, but solely a bank’s cost of funding level should never lead to a decision to target higher yielding loans to maintain a target NIM. That goes against basic financial reasoning.


The Deposit Rate Advantage


The second argument is more interesting and requires some investigation and analysis. Some bankers have pointed us to recent research done by Stefan Jacewitz and Jonathan Pogach for the FDIC that showed deposit rate advantages at the largest banks (defined as banks over $200B in size). The summary of that research is that the largest banks enjoy a significant and persistent pricing advantage for comparable deposit products and deposit risk premiums (for example FDIC insured products). When controlling for common risk variables, the authors attribute a 39 basis point cost advantage to larger banks. This advantage is attributed to and is consistent with an economically significant too-big-to-fail subsidy. 


However, a few points are worth considering to correctly frame some of the authors’ conclusions. First, the authors only considered money market accounts and no other deposits. Second, the time frame of the study was post-financial crises. Third, one variable that the authors did not control was the prevailing rate environment – lower interest rate environments advantage the national or money-centered banks. Fourth, the authors only consider the direct cost of funding, thereby discounting the higher costs that national banks incur to advertise and market their deposit products.


In considering only money market accounts, the authors overlooked community bank’s lower delivery costs for demand deposit balances and advantages for certificate of deposit accounts. Over the last five years the largest banks have averaged 3.24% non-interest expense to earning assets. That is approximately the same as the rest of the banks in the country. However, the largest banks advertising and marketing expense as a percentage of non-interest expense is 3.85% and is twice that of the rest of the banks. In other words, when allocating the largest banks’ cost of funding, another 9 to 12 basis points must be added to the cost of funding as an advertising and marketing cost that smaller banks do not incur. Because the authors only considered a short time-frame, there is serious interest rate risk bias in the data. In a low and falling rate environment, largest banks do hold a cost of funding advantage. But analyzing FDIC data from 1993 to 2013 provides a completely different picture. 


Smaller banks had a cost of funding advantage to the largest banks from 1993 through 2000 by an average of 26 basis points. During this period, interest rates were relatively high and stable.  From 2001 to 2004, during a largely decreasing interest rate period, the largest bank had a cost of funding advantage. From 2005 to 2007, the smaller banks again held a cost of funding advantage. In the post-financial crises period, when rates were declining and have maintained an extremely low level, the largest banks again held an advantage.


During the last 20 years, which includes 6 years of either zero or near-zero short-term interest rates, the largest banks show only a 15 basis point cost of funding advantage of which 9 to 12 basis points is consumed by a larger marketing and advertising budgets attributed to deposit gathering. Therefore, over the last two decades, a period that includes an unusual interest rate environment, the largest banks have had a 3 to 6 basis points advantage on cost of funding to the rest of the industry.


Now, you show us a community banker that cannot get 3 to 6 basis points more on a loan? Community banks have many competitive advantages and must align strategy and tactics to meet their objectives. Loans need to be priced according to credit and according to market and not to a bank’s current cost of funds. This isn’t to say managing cost of funding isn’t important, just that community banks should strive to leverage their cost of funds advantage over large banks as a separate endeavor. Banks that follow this way of thinking will find that their banking efforts will be much more successful.