The cost of funds for an opportunity in PrecisionLender is primarily dependent upon the funding curve selected; however, another important consideration is whether or not capital is factored in the equation. Including capital can result in a lower cost of funds and thus a higher ROE on the opportunity or the ability to charge a lower interest rate on an opportunity and still achieve your target ROE. However, because this ignores the potential cost of capital considerations, we recommend that you do not include capital in funding when using PrecisionLender.
Throughout this article we will assume the following bank’s funding curve and that no liquidity premium or adjustments are made to this curve. Further, we will assume that the capital requirement on all loans discussed is 8% for each month the loan exists.
Including Capital in Funding
The main reason for including capital is the idea that if a loan requires a certain amount of capital, then this should be part of the funding with the remainder being funded by your wholesale funding source, deposits, or other liabilities. This provides a balance between the loan assets and the items that would fund it. Since capital has no direct cost of funds, the capital portion of the funding has a zero rate. Thus, the total cost of funds for the loan would only be that associated with the liabilities, which generally represent 85% to 93% of the loan.
Including capital will reduce the cost of funds as a percentage of the average balance. On a $1,000 interest only loan when capital is included the average balance of costing liabilities would be:
- (1 - 8%) x (Loan Amount of $1000) = $920.
The cost of funds would be reduced by 10 basis points for a six month loan based on the funding curve above (8% x 1.25%). On a fully amortizing loan the reduction would be 7.5 basis points.
Excluding Capital from Funding
The primary reason for not including capital is the idea that there should be a cost for capital. Many funds transfer systems apply a cost to capital since it is expensive to raise and maintain. Excluding capital from the funding costs implies that there is some charge (that being the liability cost of funds) on the percentage of the loan supported by capital. While it can be argued that this may be too low, the ROE obtained on the loan is meant to reflect the return to the capital providers. Excluding capital also eliminates the issue with the varying value to the profitability of the loan based on the interest rate environment.
When interest rates are relatively low, the effect on the total cost of funds is minor. However, in a higher interest rate environment, the effect is more significant. For example, including capital reduces the total cost of funds by about 7.5 basis points for a fully amortizing loan, but during 2006 when the funding curve was in the 5% range the difference would have been about 0.40%. The effect on ROE is between .5%-1.0% in the lower rate environment, but could be in the 3-5% range during the 2006 interest rate environment.
PrecisionLender recommends that you do not include capital in funding. We feel this provides a more realistic appraisal of profitability, particularly in a higher interest rate environment.
For more information on how to include or exclude capital from funding costs, see The Region Edit Screen.
For more information on setting up or editing funding packages, see Setting Up Funding Packages.