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Advances: A Practical Complement to Deposit Growth?

The cost of funding community banks in FHLBank Pittsburgh’s region is on the rise, as the rates of their two main sources of funding – deposits and advances – continue to increase. Faced with mounting emphasis on the liability side of the balance sheet, community banks can benefit from reviewing their deposit and advance opportunities to determine their true marginal cost of funds. Banks who do so effectively will satisfy customer relationships, mitigate interest rate risks and, of course, reduce overall costs.

Some banks believe that funding should only occur through deposit growth. Many times, these institutions limit asset growth until they acquire deposits. Additionally, depending on the market, these institutions may be paying up for deposits. Other banks freely participate in the wholesale funding market and use advances to fund asset growth, only pulling in deposits when they effectively can. In truth, there are benefits to both sources of funding.

The Double-edged Sword of Deposits

It’s common knowledge that deposits are the traditional source of funding for community banks. The real benefit of deposits is the access they give banks to depositors. Cross-selling products and services to depositors is invaluable for asset growth. The ability to segregate those “true customers” – those who take advantage of additional products and services – makes deposit-pricing decisions a lot easier. The problem facing many community banks is trying to satisfy those “other depositors” – investors who are strictly rate driven.

In the first quarter of 2006, roughly one-third of FHLBank Pittsburgh members experienced deposit loss. Most of the deposit growth went to larger financial institutions that have access to a larger marketplace, as well as hedging capabilities. Should community banks try to compete in the current environment? And can advances still play a part in their funding needs?

Deposit growth and loss of FHLBank Pittsburgh banks and thrifts
from 12/31/05 to 3/31/06

Advances Offer a Growth Option

Unlike deposits, advances provide instant access to funding, giving banks the ability to fill funding gaps when needed. Advances can also be structured to support certain assets, which in turn helps to mitigate interest rate risks. But which source of funds is more cost-effective? To be sure, all banks should conduct a “marginal cost of funding” analysis that takes into account the cost of deposit cannibalization.

Conducting a marginal cost analysis requires first gathering current pricing data of the liquidity markets. Currently, the average deposit cost for FHLBank Pittsburgh’s region is roughly 2.70%. CD specials have shown rates as high as 5.50%. As of July 20, 2006, the 3-month rate for FHLBank Pittsburgh advances was 5.58% and the five-year rate was 5.70%.

A Funding Analysis Example

If a bank were, for example, looking to attract $1MM in deposits, it may need to match or better the 5.50% rate, while also taking into account the cannibalization of current deposits. If $100,000 of the bank’s current deposits migrated to CDs with the 5.50% rate, the new money would actually cost 5.81%. The calculation is as follows:

90% of the $1MM is new accounts with an annual cost of $1MM x 90% x 5.50%, or $49,500.

The bank is also losing lower-cost deposits, which are migrating to the 5.50% CD. The additional cost of these migrating deposits is the difference between the new rate of 5.50% and the current cost of 2.70%, or an additional cost of 2.80% on 10% of the $1MM. The additional annual cost of the cannibalized funds would be $1MM x .10 x 2.80%, or $2,800.

The total annual cost of this deposit-attraction strategy would be $49,500 (cost of $900,000 of new deposits) plus $2,800 (cost of $100,000 of converted deposits), or $52,300 annually. If the new annual cost of $52,300 is divided by the new gathered deposits of $900,000, the actual cost to acquire the new deposits is 5.81%. In this example, FHLBank Pittsburgh advances – at either 5.58% (3-year) or 5.70% (5-year) – would be the less costly of the two funding vehicles.

Successful Banks Do Their Homework

With the ever-increasing need to reduce funding costs, community banks can benefit from conducting a “marginal cost of funds” analysis, along with other quantitative and qualitative examinations of funding, to determine the best overall strategies. When banks know and segregate their true customers, they can provide relationship pricing and can use advances for terms and structures not available from the customer base. Taking the time to manage funding allows banks to reduce overall funding costs or, at the very least, limit any additional funding costs associated with the current market.