Cost of Funds

Cost of funds is the interest cost a bank pays for deposits, borrowings, and other interest-bearing funding, expressed either as a dollar expense or as a rate over a stated funding base. The denominator matters: interest expense divided by average interest-bearing liabilities is not the same measure as interest expense divided by average earning assets.

Analysts also distinguish the average cost on existing funding from the marginal cost of obtaining the next dollar of funding. A bank may report a low historical average while facing a much higher current rate on new deposits or wholesale borrowing.

Key Takeaways

• Cost of funds can mean an interest-expense amount, an average funding rate, or a marginal funding rate; identify which one is being used.
• Average cost of interest-bearing funds divides annualized interest expense by average interest-bearing liabilities.
• Regulatory performance reports may show cost of funding earning assets, which divides interest expense by average earning assets.
• Non-interest-bearing deposits have a zero contractual interest rate but still have operating, liquidity, and relationship costs.
• Cheap funding is not automatically stable funding; concentration, maturity, collateral, and withdrawal behavior matter.
• A rising cost of funds can reduce Net Interest Income and Net Interest Margin if asset yields do not rise enough to offset it.

Common Cost-of-Funds Measures

These measures answer different questions. A page, filing, or model that says only cost of funds without naming the balance base and period is incomplete.

Average Cost of Interest-Bearing Funds

Interest-bearing liabilities can include:

• savings and money market deposits;
• time deposits and certificates of deposit;
• brokered, reciprocal, or listing-service deposits when interest bearing;
• federal funds purchased and repurchase agreements;
• secured advances and central-bank borrowing;
• senior or subordinated debt; and
• other wholesale or institutional funding.

The exact population depends on the reporting or management definition. An analyst should reconcile the denominator to the balance-sheet categories that generated the interest expense.

Worked Example

Assume Bank D reports these annual average balances:

The average cost of interest-bearing funds is:

This 2.64% rate is weighted by average balances. It is not the simple average of 2.30% and 4.00%.

Cost of Funding Earning Assets

Suppose the same bank has $900 million of average earning assets. A bank performance report may calculate:

The 2.20% result is lower than 2.64% because the denominator is larger. It does not mean the bank paid only 2.20% on its interest-bearing liabilities.

Using the common earning-asset denominator allows Net Interest Margin to be decomposed as:

If Bank D’s Yield on Earning Assets is 5.41%, its NIM is approximately 5.41% - 2.20% = 3.21%.

Marginal Cost of Funds

The marginal cost is the expected cost of obtaining or retaining incremental funding now. It can differ sharply from the average cost embedded in existing balances.

For example, assume Bank D needs $100 million of additional one-year funding and can choose between:

The quoted coupon is not necessarily the all-in marginal cost. Fees, hedges, collateral use, reserve or liquidity effects, and the probability that funding remains available at renewal can change the economic comparison.

Loan pricing based only on the historical 2.64% average cost could understate the cost of funding a new asset if the relevant marginal source costs about 4%.

Mix-Shift Example

Suppose $100 million of non-interest-bearing deposits leaves and the bank replaces it with wholesale funding costing 4.50%. Total funding remains unchanged, but annual interest expense rises by:

If asset balances and yields do not change, NII falls by $4.5 million. The example illustrates why total deposit growth alone does not explain funding cost; product mix and replacement source matter.

Deposit Beta

Deposit beta describes how much a deposit rate changes relative to a selected market or policy rate over a stated period:

If a deposit rate rises from 1.00% to 2.50% while the chosen reference rate rises by 3.00 percentage points, the cumulative beta is 1.50 / 3.00 = 50%.

Beta is not a fixed property. Results vary by product, customer, channel, competitive market, starting rate, time window, and whether the calculation is cumulative or incremental. Deposit runoff must be considered alongside repricing: a low rate is not valuable if balances leave.

What Changes Cost of Funds?

Market and Policy Rates

Benchmark rates influence deposit and wholesale pricing, but pass-through differs by instrument and customer. Contractual fixed-rate funding can delay the effect, while overnight or indexed funding can reprice quickly.

Funding Mix

Non-interest-bearing deposits, savings accounts, time deposits, brokered deposits, secured borrowings, and long-term debt carry different rates, maturities, operational requirements, and stability characteristics.

Competition and Customer Behavior

Customers can migrate from transaction accounts to higher-yield products or move funds to another institution. Digital channels can make repricing and outflow faster.

Credit and Liquidity Perception

Creditors may demand higher rates, more collateral, or shorter terms when they perceive greater risk. A funding rate can rise before a loss appears in accounting earnings.

Currency, Term, and Optionality

Funding in different currencies or maturities should not be compared by coupon alone. Embedded withdrawal rights, call features, early-redemption terms, and hedging costs can affect value.

Fees and Internal Allocation

Broker fees, issuance discounts, commitment fees, deposit-servicing costs, and internal funds-transfer-pricing charges may be relevant to product economics even when they are not reported as interest expense.

How to Analyze Funding Cost

1. Name the measure: Dollar interest expense, average funding rate, earning-asset funding cost, marginal cost, or all-in economic cost.
2. Confirm the denominator: Average interest-bearing liabilities, total deposits, total liabilities, or average earning assets.
3. Confirm annualization: Quarter, year to date, full year, and day-count method.
4. Reconcile funding mix: Non-interest-bearing deposits, retail deposits, time deposits, wholesale funding, secured borrowing, and debt.
5. Separate rate and volume: Identify repricing, mix migration, growth, runoff, and acquisition effects.
6. Measure concentration: Large depositors, channels, maturities, currencies, and counterparties.
7. Compare average and marginal cost: Historical expense can lag current replacement economics.
8. Connect to liquidity: Maturity, collateral, encumbrance, borrowing capacity, and stress runoff.
9. Connect to earnings: Asset yield, NII, NIM, hedges, credit cost, and operating expense.

Risks and Limitations

• Denominator risk: Different published ratios can carry the same label but produce different results.
• Average-cost lag: Existing fixed-rate funding can hide the rate faced on renewal or replacement.
• Behavioral uncertainty: Nonmaturity deposits have no contractual maturity, so value and duration depend on customer behavior.
• Liquidity tradeoff: The lowest-rate source may be concentrated, short term, collateral intensive, or vulnerable to runoff.
• Transfer-pricing judgment: Internal funding charges allocate economics but are not the bank’s external accounting cost.
• Cross-bank comparability: Deposit franchises, currencies, business models, and regulatory frameworks differ.

Common Mistakes

• Using average earning assets without labeling the result cost of funding earning assets.
• Averaging quoted rates without weighting balances.
• Treating non-interest-bearing deposits as economically free.
• Pricing new loans from an old average cost rather than relevant marginal cost.
• Ignoring fees, hedges, collateral, maturity, and rollover risk.
• Assuming a low deposit beta means deposits are stable.
• Comparing banks without checking funding mix and denominator definitions.
• Treating cheaper funding as proof of lower overall risk.

Authoritative Sources

• FFIEC Uniform Bank Performance Report User’s Guide provides asset-yield and funding-cost ratio definitions and formulas.
• FDIC Quarterly Banking Profile reports bank earnings and funding trends.
• FDIC QBP Graph Book publishes annualized cost-of-funding-earning-assets series.
• OCC Comptroller’s Handbook: Earnings addresses funding costs, margin analysis, earnings quality, and risk.

Related Terms

• Net Interest Income: Interest income minus interest expense.
• Net Interest Margin: Annualized NII relative to average earning assets.
• Yield on Earning Assets: Interest income relative to average earning assets.
• Certificate of Deposit: Interest-bearing deposit with a stated term.
• Liquidity Risk: Risk of failing to meet obligations without unacceptable loss.

FAQs

This article provides general financial education, not banking, accounting, regulatory, deposit-pricing, legal, tax, or investment advice. Funding definitions, classifications, costs, and risks depend on the institution, period, currency, instruments, reporting framework, and jurisdiction.