Since the conclusion of the 2008 financial crisis, the financial services industry has left its “crisis-response mode,” but we’re not in the clear yet. Many institutions emerged with their balance sheets in different stages of health. Though the economy continues to grow, we need more than a one-size-fits-all solution to get back on track.
More than 10 years out, what was most important lesson of the 2008 financial crisis? We learned that net interest margins can compress quickly—and stay compressed—much longer than anyone expects or models predict. Quickly: Net interest margins measure how successfully a firm invests its funds versus its expenses on the same investments.
These periods of margin compression revealed how little control we, as financial institutions, exert over our return on assets versus market forces: a growing concern for the ever-changing industry. Fortunately, one solution on the deposit side improves metrics that help institutions absorb more of these yield fluctuations.
Battle of the acronyms: COF versus COD
Learning the acronym COF was one of our first lessons as banking professionals. The cost of funds (COF) stands as one of the most important indicators of profit for most financial institutions. Without a close eye on COF, banks and credit unions expose themselves to interest rate risk, among other downsides—with possible long-term, damaging effects. Unfortunately, COF falls short when determining the true checking account costs, which are an important factor in any consumer’s relationship with their primary financial institution. Checking accounts also help banks and credit unions create new relationships vital to long-term success. Because COF can’t approximate the true cost for these accounts, we can’t confidently predict an accurate profit.
Strategic funding decisions based primarily on COF can’t account for non-interest expenses or the non-interest income associated with transaction accounts. This puts banks and credit unions in danger of costly mistakes. For example, consider a free checking account. While it has zero cost of funds, multiple marginal expenses must be considered, such as processing checks, sending paper statements, core fees and more. Other sources of non-interest income exist, such as debit card interchange and overdraft revenue. To consider all these components, we must look beyond COF and the holistic view of these metrics is referred to as the cost of deposits (COD).
Transaction accounts are comparatively new in the long history of banking; overdraft and interchange revenues are even newer. Accurately including these amounts into COD hasn’t become mainstream — yet. With the banking industry in the midst of historic times, now marks the moment to change that.
The COD approach helps institutions allocate non-interest expenses and revenues to the accounts that generate them. As a result, a transaction account’s value as a lower cost/higher margin funding source becomes clear—and we can recognize the true marginal value of checking accounts. Exposing this new data source helps financial institutions strategize for maximizing that revenue and attracting the most valuable account holders.
Institutions have used reward-based checking accounts in the last decade to drive revenue and draw valuable consumers. Because they are free and include the potential to earn rewards, consumers find them much more appealing. For some banks and credit unions, reward checking may seem like an unjustifiable expense. But using COD to examine reward-based accounts reveals much higher profitability than most deposits institutions use to fund their balance sheet today. This profit-per-account increase is amplified even more by the number of new account holders that reward checking accounts attract.
The holistic COD approach reveals the potential to add millions of dollars in direct income to an institution. It shows how high-yield checking accounts, combined with the profit margins on each account before reinvesting the deposits, can produce substantial revenue and engaged consumers.
During the industry’s most recent period of rising rates, the Effective Federal Funds Rate jumped from 1.00 percent to 5.25 percent, according to the Federal Reserve Bank of St. Louis. During that same period, net interest margin across the industry remained relatively stable, only shifting from 3.50 percent to 3.34 percent. COF was on the rise, but institutions were protected by a near-matching increase in reinvestment rates. However, this resulted from a firmer lending market and more generous investment opportunities, neither of which apply in today’s rising rate market. Some institutions use these previous trends as a solid model for future expectations. Yet many don’t trust those odds.
Parting thoughts: Pumping up the portfolio
The Federal funds rate continues its steady climb but regulatory changes have suppressed investment opportunities. Combined with sluggish loan demand, this is causing a unique type of compression. Through a COF view, an institution’s best response would be to raise loan rates and hope competitors quickly follow, risking lost business. Given the soft market, increasing rates cannot solve current margin compression issues. Institutions in our current environment need to capitalize on the COD approach to reveal new opportunities for increased profitability.
In light of COD advantages, it’s easy to see why COF is no longer the favorable approach. Using COD lets us recognize the significant profit margin of high-yield checking accounts, magnified during margin compression periods. For this reason, many banks and credit unions are adopting low COD transaction deposits as an important part of their deposit portfolio. Their bottom lines, both present and future, benefit as a result. If not in the clear, at we can clearly spy the way forward.
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