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AVERAGE COST OF FUNDS OBJECTIVE: Determine the average cost of funds.

In this assignment you will determine your average cost of all funds. By comparing your average cost of funds with a benchmark such as prime, you can see if you are managing your bank's liabilities efficiently and profitably. The prime rate in the economy (from the printout, page 7) is derived with a formula that uses a variety of current interest rates, so it reflects the average cost of money. For "All Banks in Economy," the interest rates for various loan categories are based on the prime rate plus a factor for operating expenses, normal loan losses, and profit. Your average cost of funds is not an absolute indicator of your bank's profitability, but you can use it to spot unhealthy trends. You should continually monitor the difference between your average cost of funds and prime. If you are able to lower costs compared to prime, you may have an advantage that you can exploit by offering loan prices lower than your competition. If your bank's average cost of funds starts to increase compared to the market prime, you want to be certain you have ways to recover these costs on the asset side. Otherwise, the bank's spread will shrink, and this will lower the bank's profits. You can use your comparison of your average cost of funds and prime to determine when to change your funding mix. As the profitability assignments on the specific demand and time deposit accounts show, your funds are a blend of different types of money with rather different costs. (See Profitability: Money Market Savings and CD's, Profitability: Public TD's and Public DD's, and Profitability: Commercial and Regular DD's in later sections) When you change the funding mix, you can change the average cost of funds. For example, when the average cost of funds is somewhat below the going market for CD's, if you increase CD's, your average cost of funds relative to the market will increase. You will narrow the bank's average spread, unless you take counter measures such as pricing your loans higher. You can also use cost of funds information to evaluate the effectiveness of a particular strategy. For example, if your team begins to increase premises, advertising, and officer time, you need to know if you are incurring all these extra expenses for any benefit. You would hope that as a result of such policies, you would have either a much larger pool of deposits for a lower cost or higher fee income. From the data on page 8 of the printout (net interest income and fee income), you can evaluate the effect of your decisions compared to the other banks. If you are not doing well, you need to find out why. However, be cautious about drawing quick conclusions from any single piece of data. For example, if you lowered your money market rate below the market rate, your cost of funds would tend to be lower on a short-term basis. But over a longer period, your cost of funds might increase, if (as a result of the lower rate) account balances shrink and operating expenses remain the same. Use the following equation to determine the bank's average cost of funds in a quarter. For example, this is the average cost of funds for quarter 2.1.

Net deposits (from Balance Sheet, page 1): Total Deposits plus Fed Funds Purchased plus Funds Borrowed from FRB minus Cash and Due From Banks Net Deposits Average cost of funds: Non-Interest Expenses Fed Funds Purchased times Category I Quarterly Expense Multiplier (85.42 x .00086) (Commercial Demand Deposits - page 2, note 2 plus Due-To-Banks - page 2, note 2 plus CD's - page 2, note 3 plus FRB Borrowing) times Category II Quarterly Expense Multiplier [(691.803 + 137.566 + 855.420 + 0) x .0030] (Public Time Deposits - page 2, note 3 plus Public Demand Deposits - page 2, note 2 plus Money Market Savings - page 2, note 3 times Category III Quarterly Expense Multiplier [(295.061 + 196.934 + 1740.220) x .0030] Regular Demand Deposits (page 2, note 2) times Category IV Quarterly Expense Multiplier (509.410 x .0055) Total Non-Interest Expense plus Total Interest Paid (Exclude Capital Note Interest: page 2, note 7) (60.905 - .894) minus Net Service Charge Income (page 2, note 9) Total Cost times 4 to annualize Annual Expense divided by Net Deposits (from above) Average Cost of Funds $ 4426.413 $ 85.420 $ 0.000 $ 359.398 $ 4152.435

0.073

5.054

6.697

$ $ $

2.802 14.626 60.011

$ $ x

4.553 70.084 4

$ 280.336 $ 4152.435 .0675 or 6.75%

From this example, we can see that for period 2.1, the bank's average cost of funds (6.75%) is 2.85 percentage points below the economic prime rate for the quarter (9.6%).

This average cost of funds is a broad measure of overall funding costs. It provides the "big picture" of your funding expenses. What is important is how the spread between different asset categories (such as the loan rates) and the average cost of funds changes from quarter to quarter (or differs between competing banks). If you want to project next quarter's cost of funds, determine the current quarter's spread from prime, and then adjust next quarter's cost of fund's by that amount. For example, in 2.1, the bank's cost of funds was 285 basis points below prime (9.6 - 6.75), so you can forecast that the bank's cost of funds for 2.2 will be 7% (9.85 - 2.85). The average cost of funds will change from quarter to quarter depending upon the economy, your deposit mix, and of course, your decisions. The bank's pledging and reserve requirements, which also affect the cost of funds, are defined by regulation, so you have no control over them.

AVERAGE COST OF FUNDS Net deposits: Total Deposits plus Federal Funds Purchased plus Funds Borrowed from FRB minus Cash and Due From Banks Net Deposits Average cost of funds: Non-Interest Expenses Fed Funds Purchased times Category I Quarterly Expense Multiplier (Commercial Demand Deposits - page 2, note 2 plus Due-To-Banks - page 2, note 2 plus CD's - page 2, note 3 plus FRB Borrowing) times Category II Quarterly Expense Multiplier (Public Time Deposits - page 2, note 3 plus Public Demand Deposits - page 2, note 2 plus Money Market Savings - page 2, note 3) times Category III Quarterly Expense Multiplier Regular Demand Deposits - page 2, note 2 times Category IV Quarterly Expense Multiplier Total Non-Interest Expense plus Interest Expense (Exclude Capital Note Interest: page 2, note 8) minus Net Service Charge Income (page 2, note 9) Total Cost times 4 to annualize Annual Expense divided by Net Deposits (from above) Average Cost of Funds $ $ $ $____ $

$____ $ $ $____ $ x $ $____ or %