Funding Availability and Strategy for different types bank There is substantial variation among bank even in similar. The average small banks uses less of liabilities and borrowing. It has higher net noninterest expenses. The midsize banks yield, cost of fund and interest are similar of small bank. The larger bank had significantly higher funding cost because of more borrowing and other expensive funding sources.

The effect of funding composition for a different size of banks There are large variation in products offered and in sources of funding. Large banks usually have much more extensive ability to use financial markets and multi borrowing sources than smaller banks.

Measuring and using the cost of fund There are three reasons about the banks interested in measuring the cost of fund : 1- the bank will generally seek the lowest cost combination of funds sources available in its markets. 2- a reasonably accurate cost of funds measure. 3- the types of sources of fund a bank obtains and the employment of these sources have a significant influence on the bank liquidity risk, interest rate risk, and capital risk

Methods of Measuring the Cost of Fund of Bank There are three methods for measuring fund. 1- a historical average cost method. 2- marginal cost of specific sources of funding. 3- weighted average expected cost of all sources.

Average Historical Cost of Funds Many banks incorrectly use the average historical costs in their pricing decisions The primary problem with historical costs is that they provide no information as to whether future interest costs will rise or fall. Pricing decisions should be based on marginal costs compared with marginal revenues 1-The weight average interest cost = interest cost. all deposits and borrowing 2- Weighted average cost interest bearing fund = Interest Cost. Interest bearing Fund

Earning requirements based on weight average cost of fund a cover interest expenses : = interest cost earning assets B- To break even = interest + net nininterest expenses earning assets Earning assets = total assets – premises and fixed assets – real estate owned and good will – cash and due from inst. – short term instruments. Net non int. = non int. – non income C- to earn 15% return on equity = Earning to cover ROE = (%ROE before tax) x Equity /earning assets Notice : ROE before tax = ROE /(1-%tax) Required co cover expenses and ROE= Break even % + earning to cover ROE

Implement percentage ( example p.220) 1-The weight average interest cost = interest cost. all deposits and borrowing = / = 3.76% 2- Weighted average cost interest bearing fund = Interest Cost. Interest bearing Fund = 16728/ = 4.42% a cover interest expenses = = interest cost = 16728/ = 6.59% earning assets B- To break even = interest + net nininterest expenses = = 6.59% earning assets net nininterest expenses = earning assets = = Earning to cover ROE = (%ROE before tax) x Equity /earning assets = 0.15/(1-0.34) x 36292/ = 8.52%

Measuring the Cost of Funds Marginal Cost of Funds Marginal Cost of Debt Measure of the borrowing cost paid to acquire one additional unit of investable funds Marginal Cost of Equity Measure of the minimum acceptable rate of return required by shareholders Marginal Cost of Funds The marginal costs of debt and equity. The bank would use its marginal cost to determine the cost paid to produce one additional unit of usable funds and determine the acceptable return on additional assets. Mechanism: 1- determine single sources of fund 2- compute the marginal cost 3- use the cost as a basis for pricing new assets

Marginal cost of fund, from single sources = Interest cost +other cost 1- non interest assets p.225

Measuring the Cost of Funds Costs of Independent Sources of Funds It is difficult to measure marginal costs precisely. -Management must include both the interest and noninterest costs it expects to pay and identify which portion of the acquired funds can be invested in earning assets. Marginal costs may be defined as :

Measuring the Cost of Funds Costs of Independent Sources of Funds Example: Market interest rate is 2.5% Servicing costs are 4.1% of balances Acquisition costs are 1.0% of balances Deposit insurance costs are 0.25% of balances Net investable balance is 85% of the balance (10% required reserves and 5% float)

Measuring the Cost of Funds Weighted Marginal Cost of Total Funds –Steps to compute WMC 1-Forecast the desired dollar amount of financing to be obtained from each individual debt and equity source 2-Estimate the marginal cost of each independent source of funds 3-Combine the individual estimates to project the weighted costs, which equals the sum of the weighted component costs across all sources

Measuring the Cost of Funds Weighted Marginal Cost of Total Funds Steps to compute WMC -Management should combine the individual estimates to project the weighted cost, where w j equals each source’s weight and k j equals the single-source j component cost of financing such that:

Measuring the Cost of Funds Example