Question

when calculating its cost of funds, should bank use average or marginal costs? Why

Answer 1

Answer:

Cost of Funds:

The cost of funds is a reference to the interest rate paid by financial institutions for the funds that they use in their business. The cost of funds is one of the most important input costs for a financial institution since a lower cost will end up generating better returns when the funds are used for short-term and long-term loans to borrowers.

The spread between the cost of funds and the interest rate charged to borrowers represents one of the main sources of profit for many financial institutions.

Key Points

• The cost of funds is how much banks and other financial institutions must pay in order to acquire funds.
• A lower cost of funds means a bank will see better returns when the funds are used for loans to borrowers.
• The difference between the cost of funds and the interest rate charged to borrowers is one of the main sources of profit for many banks.

Understanding the Cost of Funds:

For lenders, such as banks and credit unions, the cost of funds is determined by the interest rate paid to depositors on financial products, including savings accounts and time deposits. Although the term is often used with regard to financial institutions, most corporations are also significantly impacted by the cost of funds when borrowing.

Cost of funds and net interest spread are conceptually key ways in which many banks make money. Commercial banks charge interest rates on loans and other products that consumers, companies, and large-scale institutions need. The interest rate banks charge on such loans must be greater than the interest rate they pay to obtain the funds initially—the cost of funds.

Cost of Funds Are Determined As below:

Sources of funds that cost banks money fall into several categories. Deposits (often called core deposits) are a primary source, typically in the form of checking or savings accounts, and are generally obtained at low rates.

Banks also gain funds through shareholder equity, wholesale deposits, and debt issuance. Banks issue a variety of loans, with consumer lending comprising the lion's share in the United States. Mortgages on property, home equity lending, student loans, car loans, and credit card lending can be offered at variable, adjustable, or fixed interest rates.

The difference between the average yield of interest obtained from loans and the average rate of interest paid for deposits and other such funds (or the cost of funds) is called the net interest spread, and it is an indicator of a financial institution’s profit. Akin to a profit margin, the greater the spread, the more profit the bank realizes. Conversely, the lower the spread, the less profitable the bank.

Important: The cost of funds shows how much interest rates banks and other financial institutions must pay in order to acquire funds.

Conclusion:

Banks use Average Costs to determine the Cost of  Funds

Cost of funds is calculated by taking the total annualized interest expense divided by average interest bearing deposits and other interest bearing borrowings, plus non-interest bearing deposits. This equation does not include capital, although many financial institutions will include capital in an assets calculation.

The cost of funds is basically the bank's own interest rate for using their customers' money. A bank's cost of funds is then used to determine the interest rate it charges its customers for loans. Divide the bank's total interest expenses for the year.