Accounting tells us that any asset is funded by a combinations of liabilities and/or equity. If you ask any CEO or CFO of an institution they can usually cite their current average cost of funds of their institution. This would be the average cost paid on deposits and capital that are then used to fund those assets or loans.
For the past decade or so, with both short term and longer-term interest rates being low compared to levels seen in the 1970s-early 2000s. Rates have been comparatively stable. These stable low rates result in a very low cost of funds when looked at on a snapshot basis. The question is if this is a correct manner to view your cost of funds. After all, understanding your cost of funds is the first step in building the interest rates that will be charged on the loans. The loan rate should be figured by taking the cost of funds, figuring an adequate margin which considers loan interest rate duration, loan loss reserves, and management costs. I have seen some shops that subscribe to a logic of identifying the static net interest margin as they compete for loan deals with super-low interest rates. This is often done without any consideration of the cost of managing the credit, booking and maintaining the loan, and loan loss reserve expenses.
I argue that a simple snapshot view of your current cost of funds is not the best way to form the basis of your institutions cost of funds when forming the basis for the interest rate you will charge on your loans, today. The global interest rate environment has been so low for so long could deceive you to understanding the cost of funds in the future. One problem with history is that we tend to stay in our short attention span and make decisions in that scope without considering a longer-term view of where rates have been in the past. As rates increase and the overall cost of funds rises, looking at your static cost of funds which have been so low for so long, will miss the expected future increases in the near term. Even if rates stay where they are now, your cost of funds will increase as many non-bank and non-traditional banking sources will become an attractive alternative for many of your customers to move some of the 0% earning deposits that you have enjoyed for so long. This may force you to begin to compete on rate for deposits, which raises your cost of funds.
Early in my commercial career, I learned the concept of pricing using a “matched fund” method. This strategy assumes that you have no money on your own to loan. You must reach out to some source like the US Treasury or FHLB in order to fund the loan. The loan funding term will match the term of the pricing on the loan, i.e. a three-year ARM would be tied to a 3-year US Treasury, a five-year balloon would be tied to the 5-year FHLB rate. The net interest margin (NIM) spread is the difference between the interest rate on the loan and the underlying cost of funds.
Pricing loan using matched funds to determine the NIM gives a truer picture of the actual cost you would incur to fund the loan. Tying adjustable rate loans to a similar index in maturity also give you a picture of your cost if you were forced to borrow funds when the loan matures or adjusts to re-fund the credit facility. This is basically focusing on the margin pricing.
This pricing strategy may increase your overall yield on the loans if you are currently figuring NIM on a very low static cost of funds. It should help your earnings comparably to the static view, especially when involved in a low interest environment with possible increasing interest rates, such as we are now. If interest rates and your cost of funds is very high at the top end of an interest rate cycle, adjustments to this strategy should be considered to maintain strong NIM profitability.