In our series ‘Bank jargon made relevant’, we explain frequently used words, acronyms and concepts that feature in banking discussions. An awareness of these concepts will help remove some of the intended confusion and assist in your next bank negotiation.
Cost of funds
Banks’ funding costs
Cost of funds is the interest rate the bank must pay for the money they use to fund their loans, or more formally known as ‘asset book’. This interest rate is the blended rate from several sources, such as customer deposits, capital and short- and long-term wholesale, with each source having a different rate.
Each source of funds makes up a certain percentage of total cost of funds;
- Around 60%-70% from customer deposits (low cost and stable)
- Less than 10% from capital (cost of equity)
- About 10% from short-term wholesale funding (moderate cost)
- About 15% from long-term wholesale funding (high cost).
The cost of each source of funds depends on its composition and interest rate. Let’s consider the following example sources of funding:
Wholesale funding via offshore senior unsecured bond issue:
- Pay bond holds fixed coupon @ 1.50% for 3yrs.
Total Cost of Funds = 1.50%,
This could be made up of a 3mth BBSY (0.30%) and cost of wholesale funds (1.20%, or 120pts).
Customer deposits, transactional accounts receiving 0.01% interest:
- Pay deposit holders 0.01%
Underlying risk-free reference rate: ~0.25%
Banks effectively earn 0.25% on deposit holder’s balances.
“Cost of funds” is actually -0.24% (yes, a negative as banks earn money on this source of funds.)
As you can see, there can be quite a difference in cost of funds between each source.
Bankers often talk about cost of funds interchangeably with wholesale funding costs, despite wholesale funding comprising of less than 30% of cost of funds. Bankers often present charts showing volatile market data series and elevated costs. It might be familiar to hear a banker say, “just look at where the AA- rated bank issued three-year funds at!”.
While this is important, wholesale funding has a more subdued effect on cost of funds due to the portfolio effects of multiple sources and term.
Impact on margin
Cost of funds has a direct impact on margins as a cost pass through. It is the role of a bank’s central treasury function to skillfully manage market volatility and balance sheet dynamics via transfer pricing mechanism to provide margin stability for customers.
For the past 15 months, banks have replaced wholesale funding with extremely low-cost funding thanks to the Reserve Bank of Australia’s (RBA) Term Funding Facility (TFF). This cheap funding source is locked in for 3 more years and will progressively lower the portfolio cost of funds are old “expensive” funding expires.
Offsetting this is the impacts from a low-rate environment reducing the ‘free-kick’ previously afforded to the banks from low and zero interest deposit accounts.
What to be aware of
When negotiating your margin, watch out for the over-emphasis on wholesale market movements, be informed about the cheap RBA provided funding sources but don’t discount the low-rate environment impacts.
Match-funded loan pricing
Match-funded loan pricing is where a term loan is offset by an equivalent term of funding. For example, when a 3-year fixed loan is matched with a 3-year fixed deposit, a matched-term cost-of-funds rate is set. The transaction is interest rate risk neutral and an appropriate reference point for cost of wholesale funding discovered.
Match-funded loan pricing concept comes from the asset and liability management (ALM) treasury function. The ALM treasury function manages the bank’s asset and liabilities at a consolidated level known at the ‘mismatch’ or ‘gap analysis’ and is key to determining loan pricing.
A central principle of ALM is the matching of assets and liabilities to mitigate risk. The basic concept for a single asset bank.
Match-funded loan pricing:
- A business loan, with a fixed 5-year rate and term should be matched with a 5-year ‘deposit’ in order to totally offset risk. The bank must offer a rate that attracts such a deposit, hence price discovery of the ‘cost of 5-year funding’ is found from the market.
- The bank on-lends to the business at a higher rate collects the ‘net interest margin’, the difference between loan rate and the funding rate. The bank is insulated from all future interest rate movements. And because they are matching terms of the deposit, there is no refinancing risk.
Alternative to match-funded loan pricing:
- This prudent approach is different to the trap that caught out many firms pre-GFC. Taking the same 5-year fixed rate business loan, a Bank Treasurer or property company CFO could instead choose to fund via short-term funding that is comparatively cheaper to the 5-year matched term. They benefit from cheaper rates for 3-month money and roll the funding over 20 times throughout the 5-year loan.
- They are ‘playing the curve’ and exposed to both refinancing risk and interest rate risk. The music stopped during GFC, prudently managed domestic banks were fine, but this was not the case for many once cheap liquid funding ceased during the GFC.
Impact on margin
The match-funding concept is applied to find the appropriate cost basis for the pricing of term lending. When pricing a 3-year term lending facility, a key reference point is the cost of funding for 3-years. This is central to risk-based pricing models.
However, whilst this is a fairly simple concept, it is not so clear what the appropriate reference timeframe should be. Should a 3-year facility agreed upon today be priced based on a 3-year funding that is issued today? What then if drawdown doesn’t occur for 2- or 3- or 6-months yet pricing is set?
And new funding issuances are lumpy and opportunistic based on market conditions so daily reference points do not reflect the true cost to the bank. Should it be the past 3-months average of 3-year funding issues? Should it be 6-months?
There are numerous options so we will explain how they can be used to perpetually justify increasing costs in another article.
Risk-weighted assets are the key link between your businesses lending limits and the amount of capital a bank must hold in reserve against it.
As the name implies, it is calculated as:
RWA = Risk weight x Assets
Risk weight is the percentage. Assets related to Lending Limits. For example;
RWA = 20% x $20.0m
RWA = $4.0m
There are several categories of risk weighted assets that determine a bank’s capital requirements.
- Credit risk-weighted assets
- Operational risk-weighted assets
- Market risk-weighted assets
- Interest rate risk in the banking book risk-weighted assets
An increase in risk-weighted assets results in an increase in capital requirement.
Similarly, at a ‘per lending product for a firm’ a decrease in risk weight reduces the risk-weighted assets resulting in a lower capital requirement.
Impact on margin pricing
It is highly likely your banker has used increasing capital requirements to justify a margin increase sometime over the past 10 years.
But what they may not have told you is that credit risk-weighted assets are by far the largest contributor towards a banks risk-weighted asset base. Total risk-weighted assets multiplied by APRAs capital requirement determines the capital base. A bank must earn appropriate returns on this capital base which is via fees and margins.
Credit risk-weighted assets are determined by both financial performance (firm’s riskiness) and security (firm’s collateral). Over the past 10 years whilst regulatory changes have increased capital requirements for banks, your individual firm’s financial performance and valuation of collateral may have more than offset those increases.