With interest rates on the rise and competition for deposits heating up, it is important to understand your institution’s options for funding loans and growing your balance sheet. One of the best tools you can utilize to help maximize profitability is marginal cost of funds (MCOF).  
 

Applying MCOF analysis will allow your institution to compare how different funding strategies affect the bottom line, ultimately choosing the option that incrementally adds the least to total funding costs. The simple MCOF formula is below.

MCOF captures the increase in financing costs for a business entity when it adds one more dollar of new funding. The figure at the top of page 2 illustrates the impact MCOF could have on your institution. When you consider offering a CD special or changing deposit rates, how much new money do you expect to bring in and how much do you expect to reprice from existing accounts? Using these assumptions, your institution can predict how offering a special or changing rates will affect net interest margin. You can compare this outcome with other alternatives such as brokered deposits or FHLBank funding options.
 
The examples that follow represent two different strategies, giving a high-level over-view of how the analysis works. 

SIMPLE MARGINAL COST FORMULA

Marginal Cost  =  Change in Total Cost of Deposits
                                    Change in Quantity of Deposits

Examples of strategies
In the first example, let’s consider a CD special offering for 12 months at 2.05% which attracts $5 million of new funds. We estimate current average deposit rates, comprised of upcoming CD maturities and non-maturity deposits, of around 1.15%. This is much lower than the new promotional rate, so we conservatively assume you will attract $5 million in new funds, and $2.5 million in existing deposits would reprice at the new rate. This is important to note, because although your new rate on deposits is 2.05%, the effective rate to attract these new deposits is much higher at 2.50% (see below) due to cannibalization of existing deposits.

{($5,000,000  x  2.05%)        +       [$2,500,000       x       (2.05%    -    1.15%)]}        /        $5,000,000 =            2.50%

In comparison, $5 million 12-month FHLBank fixed rate funding is currently 2.65%. While initially the CD special may look more attractive, by incorporating the 6.75% dividend paid (estimated 30 bps in savings) on activity-based stock that is purchased when taking down the advance, the overall effective rate of 2.35% shows a real cost savings. Overall, not only would you save 15 basis points on the margin when taking down an FHLBank advance, the funding is also available immediately, a luxury not available when raising funds through a CD special. 

In the second example, the same inputs are used, but instead of taking down a 12-month FHLBank advance we use FHLBank’s line of credit as the source for $5 million in new funds. The current rate on the line of credit is 2.11%; however by incorporating in your dividend, the total effective rate is lowered to 1.81%. It is important to note the rate on the line of credit reprices daily, so the effective rate of 1.81% could increase over the same 12-month period. However, you have 69 basis points of cushion before reaching the 2.50% effective rate when you provide a CD special, making the line of credit a lucrative option. If you start to see a surge in deposits, the line of credit gives you the added benefit of flexibility to pay down the borrowings with no added fee. 

 

These two examples are just a snapshot of the intricate MCOF analysis our Member Solutions staff has created. It is important to run these types of analysis to help your institution make an informed funding decision, ultimately cutting down costs and adding to your bottom line. 

How to deploy these strategies

• Meet with ALCO and your management team to discuss the MCOF approach and get their buy-in. If needed, contact your FHLBank account manager to assist with this discussion.
• Prior to raising rates on non-maturity deposits or offering any new CD or deposit specials, conduct an MCOF analysis. You could either do this internally or in partnership with FHLBank staff, utilizing tools created specifically for MCOF analysis. 
• After evaluating the MCOF analysis and selecting the most viable option, work with your team to formulate a plan to execute the strategy.
• If needed, contact your FHLBank account manager or the Lending Desk with any funding requests or questions you may have.
• Check in with your team regularly to evaluate the strategy post-deployment and make adjustments as necessary.

Let us complete your customized analysis
FHLBank has developed sophisticated tools to help you evaluate your funding options. Our Member Solutions staff wants to help with this analysis. In order to get a complete picture, we need a little information from you. If you are interested in a discussion on MCOF, please contact the Lending Desk at 800.809.2733, and we will walk you through the next steps.