FHLBInsider

By James Eibel, consulting manager, assistant vice president

Any institution with 100% retail
funding is paying too much
for its money.

--Tom Farin, Farin and Associates

It’s Tuesday morning. Just like every Tuesday morning, your "in basket" has the latest deposit rate comparison for your market. As you study the rates, you notice your primary competing institution has just increased its three-year CD rate 50 basis points above your current rate of 5% for a month-long special promotion. You estimate that 30% of your $10 million maturing CDs ($3 million) will leave if you don’t match the rate increase. What should your institution do? If the rate increase is matched, funding costs will escalate. If nothing is done, customers, and the critical funding they represent, will be lost.

Pricing dilemmas such as this happen frequently. FHLB members are well equipped to deal with these situations. Access to advance funding eliminates the threat lost depositors pose to both liquidity and liability structure. If price sensitive depositors depart for higher rates elsewhere, their funding can always be replaced with advances.

As a deposit pricing tool

While the value of FHLB advances during periods of disinter-mediation is obvious, their value as a deposit pricing tool is usually less apparent. Advances represent a source of funding diversification, which can be used for leverage in deposit pricing. In addition, they can help an institution avoid overpaying for deposits.

Marginal cost analysis is the key to incorporating advances in deposit pricing. Marginal cost can be found by dividing the incremental costs of a funding alternative by the incremental funds generated. Funding cost is minimized when the marginal cost (not the rate paid) of all funding alternatives is equal. Implicit in this concept is that funding diversification can result in cost savings over a single funding source.

In the example cited above, the marginal cost of the rate increase can be found by using the formula shown in Figure 1.

The rollover premium of 50 basis points or $35,000 is paid to loyal depositors, even though they would have been content with the lower rate of 5%. When the cost of overpaying these price insensitive depositors is factored in, the actual cost of retaining the $3 million of rate sensitive deposits is 117 basis points higher than the new rate of 5.5%!

A FHLB member faced with a similar pricing decision would have the option of maintaining current CD rates and replacing the runoff with advances. The marginal cost of this strategy is also illustrated in Figure 1.

A lower marginal cost

By ignoring the competition’s rate increase, a FHLB member could save $32,000 per year in interest expense. On a marginal cost basis, this represents over 100 basis points. This holds true even though the advance rate (5.6%) is higher than the raised CD rate (5.5%), illustrating an important concept. The marginal cost of an advance can be lower than a deposit, even if its stated rate is higher. For this reason, straight rate comparisons can be deceptive. In the case above, a simple rate comparison would have supported the more costly strategy.

To many institutions, the pricing scenario described at the start of this paper would be a competitive threat. In fact, the situation is an opportunity to decrease funding cost relative to the competition and to gain a competitive advantage.

How would the strategy affect your institution relative to the competitor conducting the CD promotion? Assume your competitor initially had the same three year CD rate (5.0%) and a similar amount of CDs maturing during the promotion ($10 million). The cost implications are illustrated in Figure 2.

Decreasing cost of funds

By keeping rates constant, your institution gave up $3 million of CDs to your competitor, but at a high cost to that institution. The competitor was forced to pay a 217 basis point premium over the old rate of 5%. By ignoring the rate increase and replacing runoff with advances, your institution decreased its relative cost of funds. Your institution paid a mere 5.6% for its new money, while your competitor paid 7.17%. Perhaps competitors will run CD promotions like this with greater frequency!

What about the lost depositors and the cross-selling opportunities they represent? First of all, a depositor leaving for higher rates is, by definition, price sensitive. Therefore, it is likely they can be reacquired by higher rates. Second, it is highly likely price sensitive depositors will be sensitive to the pricing of other products as well. For this reason, it will be difficult to recoup the premium paid for their deposits through other products and services. Last of all, price sensitive depositors inject volatility into an institution’s deposit flows. By concentrating on retaining loyal core depositors instead of bidding for price sensitive ones, an institution can reduce both deposit volatility and funding cost.

Marginal cost analysis

Incorporating advances into your institution’s deposit pricing could reduce interest costs significantly. In order to do this, marginal cost analysis must become a regular practice. For more information on marginal cost analysis or a customized analysis for your institution, call Jim Eibel at (317) 465-0423.

This article has been presented for educational purposes only.  The FHLBI is not a financial or investment advisor.   It is solely the reader's responsibility to evaluate the risk and merits of any funding strategy or business proposal.

Copyright 1993, Federal Home Loan Bank of Indianapolis