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. !or "#ll Banks in $conomy," the interest rates for various loan categories are based on the prime rate plus a factor for operating e%penses, normal loan losses, and profit. &our average cost of funds is not an absolute indicator of your bank's profitability, but you can use it to spot unhealthy trends. &ou 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 e%ploit 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. 'therwise, the bank's spread will shrink, and this will lower the bank's profits. &ou can use your comparison of your average cost of funds and prime to determine when to change your funding mi%. #s 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. ((ee 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 )hen you change the funding mi%, you can change the average cost of funds. !or e%ample, when the average cost of funds is somewhat below the going market for *+'s, if you increase *+'s, your average cost of funds relative to the market will increase. &ou will narrow the bank's average spread, unless you take counter measures such as pricing your loans higher. &ou can also use cost of funds information to evaluate the effectiveness of a particular strategy. !or e%ample, if your team begins to increase premises, advertising, and officer time, you need to know if you are incurring all these e%tra e%penses for any benefit. &ou 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. !rom the data on page , 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. -owever, be cautious about drawing .uick conclusions from any single piece of data. !or e%ample, 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 e%penses remain the same. 0se the following e.uation to determine the bank's average cost of funds in a .uarter. !or e%ample, this is the average cost of funds for .uarter 1.2.

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%

!rom this e%ample, we can see that for period 1.2, the bank's average cost of funds (3.745 is 1.,4 percentage points below the economic prime rate for the .uarter (6.35 .

This average cost of funds is a broad measure of overall funding costs. It provides the "big picture" of your funding e%penses. )hat is important is how the spread between different asset categories (such as the loan rates and the average cost of funds changes from .uarter to .uarter (or differs between competing banks . If you want to pro7ect ne%t .uarter's cost of funds, determine the current .uarter's spread from prime, and then ad7ust ne%t .uarter's cost of fund's by that amount. !or e%ample, in 1.2, the bank's cost of funds was 1,4 basis points below prime (6.3 / 3.74 , so you can forecast that the bank's cost of funds for 1.1 will be 75 (6.,4 / 1.,4 . The average cost of funds will change from .uarter to .uarter depending upon the economy, your deposit mi%, and of course, your decisions. The bank's pledging and reserve re.uirements, which also affect the cost of funds, are defined by regulation, so you have no control over them.

AVERAGE COST OF FUNDS 8et deposits9 Total Deposits plus Federal Funds Purchased plus Funds Borrowed from FRB minus Cash and Due From Banks Net Deposits #verage cost of funds9 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 %