The Cost of Funds

Considering notional versus marginal costs is vital for deposit pricing during a period of sustained low interest rates.


For some time, credit union members have been reacting to the uncertainty in the markets and their own financial situations. They have been seeking safety for their capital by migrating to short-term certificates of deposit and money market accounts, which shortens the liability structure on the credit union's balance sheet.

Credit unions won't shirk their responsibilities to meet members' needs, but this influx of cash is coming at a time when Fed funds are yielding 7 to 20 basis points, and there isn’t an offsetting demand (i.e., loans) for the funds as is the case with many credit unions. In this environment, deposit pricing decisions are critical to avoid compressed margins and lower earnings – earnings that are the source of retained earnings and capital.

What are the potential impacts of a credit union lowering the deposit yield across all products to better match the earnings from investment yields and loan income? In an extreme case, as much as 10% of the deposits might leave the institution. The corollary is 90% of the deposits remain. More significantly, they remain at a lower cost of funds that could generate cost savings. Credit unions want to reward loyal members; however, it is important to identify the rate shoppers.

In many cases, competitors in the marketplace pay premium rates to attract deposits. The industry experienced this last year when several prominent banks – with their deteriorating capital positions – no longer were able to fund their balance sheets through debt issuance and relied on retail banking as a source of funding. Should credit unions have followed suit?

Before you answer, consider the marginal versus notional cost of funds. The notional cost of funds refers to the rate credit unions pay their members. In this framework, the quick answer is to reference the competitor's rate, which then becomes a proxy for the cost of funds. The notional cost of funds is not entirely correct, as it doesn't capture the credit unions marginal cost of funds.

Similar to opportunity cost in Economic 101, the marginal cost of funds takes into account the dollars that will leave lower yielding accounts, such as a money market, in order to earn the higher (i.e., notional) rate. By taking the rate differential between the two accounts and multiplying by the dollars that migrate between accounts, the marginal cost of funds can be determined. Surprisingly, the marginal rate is oftentimes a multiple of the notional rate!

Focusing on the deposit pricing structure of your institution is a good strategy during a period of sustained low interest rates. Consider investments that provide call protection and predictable cash flows, and look for creative ways to make new – good – loans. The goal is to ensure the decisions you make today are ones that you can live with once rates begin to rise.




Feb. 1, 2010


  • Many good points in this article. I would add that good loans are not only loans that will be repaid, but that they will earn a competitive rate of return after the cost to originate and service, plus be short enough that the coming rise in interest rates will not severly reduce the CU earnings in the years to come.