LDM | Risk Management

Background

Understanding costs by the management is important not only in manufacturing and trading industry but also in today’s fast changing banking environment. Once costs are known they provide a reference point for assessing profitability and enable the management to see whether or not the expected return is satisfactory. Whatever pricing strategy a business establishment decides to adopt, it should not decide a price which is below the cost. Therefore, the cost of products or services provides key guidelines to many business establishments in setting price.

Interest Rate Spread

As a consequence of deregulation of interest rates by the central bank of many countries, banks are free to quote interest rate to their clients. This caused the narrowing down of the interest spread of banks as the market forces influenced the interest rate. The narrower interest spread has pressurized the banks to enhance efficiency in their operating system to survive under thinner margins in a buyer’s market. Sometimes, there may be a limitation in the increment in the interest spread. In such a situation, focus on cost reduction helps the management to enhance the profit.

Costing in Banking

As in case of other industry, management in a bank needs to know what its costs are. In banking industry, the cost is referred to as cost of funds. The management should compute the cost of funds for bank as a whole taking all funds raised from different sources during a particular period. In this process, they should assume that the funds are flown into a common pool and no single source of funds is related to any specific uses of funds. Also, the management should compute cost in totality irrespective of the revenue arising out of the deployment of funds in particular sector.

Cost can be termed as a resource sacrificed or forgone to achieve a specific objective. The resource of a bank could be defined in terms of funds, people, facilities, etc. Banks pay interest in procuring funds and incur expenses for hiring people and using the facilities. Therefore, cost of bank funds includes interest as well as non-interest costs. Interest cost generally represents the prime cost component in banking industry. Non-interest component consist of staff costs and other operating costs.

Measuring Cost of Bank Funds

In measuring cost of bank funds, people apply various concepts. These concepts include cost of loanable funds, historical cost of funds, marginal cost of funds, cost of total funds, etc.

Cost of Loanable Funds

Some banks use the concept of cost of loanable funds in measuring cost of funds. The concept is based on the fact that the entire volume of fund raised by the bank is not available for lending. Banks need to maintain certain cash reserve ratio (CRR) as prescribed by the central bank. Apart from CRR, banks also invest part of their funds in highly liquid assets. Such investment include investment in treasury bills, government bonds, money at call or short notice, etc. Banks generally do not earn any income from CRR, while they earn relatively lower rate of return from investments compared to loans and advances. In computing costs of loanable funds, the loss arising out of deployment of funds in CRR and investments as compared to the return from loans and advances is loaded on to the cost of funds.

The concept of cost of loanable funds is inappropriate as the proportion of loanable funds differs from bank to bank depending upon the policies of the individual banks. The policies of the banks may change from time to time based on changing banking scenario. Such policies affect the cost of loanable funds.

Historical cost of funds

Historical cost of funds is computed by dividing historical interest and non-interest expense by average of total funds of the bank. However, this concept has a major drawback. Historical cost provide no information as to whether future interest cost will rise or fall. When interest rate is in rising trend, average historical cost of funds understates the cost. The opposite will be the case when the interest is in falling trend.

Marginal cost of funds

Marginal cost of funds is a measure of the cost a bank incurs in raising additional unit of fund. The theory of marginal costing states that as long as the incremental revenue exceeds the marginal cost, it makes a contribution to the bank. Understanding marginal cost will help the bank to make pricing decision under competitive environment. Understanding marginal cost of funds also helps the bank to gain knowledge on the relative cost of different sources of funds and target for the least cost funds in order to maximize profitability.

Cost in Totality

The management should compute cost of funds of a bank in totality irrespective of the revenue arising out of the deployment of funds in particular sector. Some of the deployment of funds may not yield any revenue at all (e.g., CRR) while some may yield lower rate of return than the cost (e.g., investment in liquid assets). Even among the loans and advances, all sectors may not yield same return to the bank. Comparison of cost of total funds with the yield from deployment of funds helps the management to gain knowledge on the contribution made or loss incurred from each of the sector.

Conclusion

Measuring true and correct cost of funds helps the management for effective cost control. Measurement and analysis of cost helps in creating cost consciousness in the organization. This also helps the management to improve the profitability and competitiveness of their bank.