CostsofFundsandCapitalasinstrumentsoftheBanks

FinancialManagement

AlaaM.EzzlarabMBA,LLM

Financialintermediaries,ingeneral,andbanksinparticular,owetheirexistenceto
theseinefficienciesinthedistributionofcapitalfromthosewithasurplustothose
withaneed(Adams& Rudolf2006).In specific,banksarefinancialintermediaries,
whosecurrentoperationsconsistoftransformingdepositsreceivedfromthepublic
intoloans(Kugiel2009).Inthatprocessoffundstransfer,bankspaythecostsofthe
fundstheyacquire,andgettinginterestoverthefundstheyprovide.Asaresult,the
interest income is a main source of income to banks. The assignment of interest
income to banking products is called funds transfer pricing which is based on the
costs of funds (IJskes 1995). In particular, the cost of funds can be viewed as the
interest payments charged when one unit lends funds to another (Marrison 2002),
whether within the same bank or to another bank. Cost of funds determines the
profitabilityandtheefficiencyofthefundstransferprocess.Incomplementing,the
cost of capital works as a benchmark of capital using against the available capital
marketalternatives.Unlessabankcangaininexcessofitscostofcapital,thefund
transferwillnotaddvaluetoitsinvestorswealth(Hussain2010).Inotherterms,itis
theminimumrequiredrateofreturnoninvestmentbythecompany(Collier,Graiy,
Haslittz&McGowan2006).Also,thecostofcapitalreflectstherisklevelsadaptedby
thebank.Basedonthat,thecalculationsofcostoffundsaswellascostofcapitalare
maindeterminantsofthedecisions,whicharetakenwithinthebanks,withregardto
thefinancialmanagementandcontrol.So,inordertodemonstratetheroleofthe
costs of funds and capital in the bank financial management processes, it is
important to spot lights on their different calculations methods along with their
advantagesandlimitations.

CostofFunds

Themostaestheticallypleasingwayforaneconomisttodeterminethecostoffunds
is to "let the market decide it." (Thaler 1993). However, in practice, marginal cost
analysisisthekeytoanalyzingfundspricingstrategies.Marginalcostiscalculatedby
dividing the incremental costs of a funding alternative by the incremental funds
generated. It works like an indicator of the relative cost of different funds, which

banks can use to target the least expensive sources for financing growth. The
marginal cost of funds is constituted from the marginal costs of debts and equity.
The marginal cost of debt is a measure of the borrowing cost paid to acquire one
additional unit of investable funds. And the marginal cost of equity capital is a
measureoftheminimumacceptablerateofreturnrequiredbyshareholders(Koch&
MacDonald2009).Fundingcostisminimizedwhentheinstitutionraisesfundsata
marginal cost at or below the cost of other funding alternatives. Implicit in this
conceptisthatfundingdiversificationcanresultincostsavingsoverasinglefunding
source(Farin2009).

However,thecostofanysinglesourceoffundsmaychangemoreorlessthanthe
costofothersourcesandthusvarysubstantiallyfromthebank'scompositecostof
financing(Koch&MacDonald2009).Inresponsetothat,theuseofmarginalweights
involves weighting the specific costs by the proportion of each type offund to the
totalfundstoberaised.Theincrementalcostoffinancingaboveapreviouslevelis
called the weighted marginal cost of funds (WMC) (Groppelli & Nikbakht 2006). In
fact,theuseofmarginalweightsismoreattunedtotheactualprocessoffinancing
projects (Khan& Jain 2007). Further, the WMC principle provides a more realistic
measure for choosing the most profitable projects. Because it implicitly recognizes
thechangingresponseofinvestorstoincreasedfinancingrequirements,ittakesinto
accountthelimitsimposedbythemarketondifferentlevelsofnewfinancing.Italso
recognizes that money is a scarce resource, and that excessive financing leads to
successively higher costs (Groppelli & Nikbakht 2006). Another merit of marginal
weightsisthattheirusealsoreflectsthefactthatthefinancialinstitutiondoesnot
haveagreatdealofcontrolovertheamountoffinancingobtainedthroughretained
earningsorothersourceswhichareinfluencedbyseveralfactors,suchas,temperof
themarket,investors'preferenceandsoon(Khan&Jain2007).

But, the marginal weighting system suffers from serious limitations. One major
criticism is that this approach does not consider the longterm implications of the
firm's current financing. Since capital expenditure decisions are longterm
investmentsofthefirm,attentionshouldbegiventothelongtermimplicationsof
anyfinancingstrategy.Usingcheapersourcesoffundstofinanceagivenprojectmay
place the financial institution in a position where more expensive equity financing
willhavetoberaisedtofinanceafutureproject.Thus,thefactthattoday'sfinancing
affects tomorrow's cost is not considered is using marginal weights (Khan& Jain
2007).Further,inpractice,itwouldbedifficultandcostlytoimplementastructure
in which every individual deposit is lent separately into the market and every loan
requiresfundstobeindividuallyborrowedfromthemarket.Thepracticalalternative
is to set up an internal market that aggregates all the individual transactions, and
onlytousetheexternalmarkettoborroworlendthenetamount(Marrison2002).

Notwithstanding, the alternative to the use of marginal weights is to use historical

weights. Here, the relative proportions of various sources to the existing capital
structure are used to assign weights. In other words, the basis of the historical
weighting system is the funds already employed. The use of the historical weights
would assume that the existing capital structure is optimal hence, the existing

proportionofvarioussourcesoflongtermfundswillbefollowedwheneverthefirm
raises additional longterm funds to finance new investment projects (Khan& Jain
2007).

The problem with historical weighting is that the validity of the assumptions on
whichitisbasedisopentoquestion.Thatbanksshouldraiseadditionalfundsfrom
different sources in the same proportions in which they are in the existing capital
structureimpliesthattherearenoconstraintsonraisingfundsfromthesesources.
Yet another problem with the application of the historical weights is that a choice
has to be made between the book weights and market value weights. Further,
historicalcostsprovidenoinformationastowhetherfutureinterestcostwillriseor
fall.Also,averagehistoricalcostsoverstateactualinterestcostsonnewdebtsothat
fixedrateloansmaybepricedtoohightobecompetitive.Theuseofaveragecosts
assumes that interest rates will be constant at historical levels during the current
pricingperiod(Koch&MacDonald2009).

CostofCapital

Anothermaindeterminantinthebankfinancialmanagementisthecostofcapital.
Capitalrepresentstheportionofthebanksassetswhichdoesnothavetoberepaid
and therefore is available as a buffer in case of overestimation in the value of the
bank. Banks attempt to keep in place the minimum level of capital that provides
sufficient protection (Elliott 2009). In particular, banks with higher profitability,
fewer problem loans, and higher capital ratios pay lower interest rates when they
borrow overnight. This suggests that banks can distinguish credit risk among their
peersandpriceloancontractsaccordingly(Furfine2001).

Commonstockisthepurestformofcapitalbecausethereisnorequirementtoever
pay it back, nor is there a legal requirement to pay dividends. Preferred stock can
alsobeconsideredcapital.Apreferredshareissimilartoaloan orabond,inthat
thereisafixedclaimontheassetsofthecompany(aredemptionvalue)andan
agreeddividendratethatwillbepaidperiodically.However,itisconsideredstock
(and capital) because, unlike a loan, preferred shareholders have no right to force
thecompanyintobankruptcyifthepreferreddividendisnotpaid(Elliott2009).

Cost of capital is the expected rate of return that the relevant market requires in
ordertoattractfundstoaparticularinvestment(Paglia&Slee2010).Uponso,most
valuators use the company's cost of capital as a proxy for the discount rate or to
computetheopportunitycostofanacquisition(Reed,Lajoux&Nesvold2007).Thus,
getting the cost of capital right is very likely to be a firstorder consideration for a
financialinstitution(Froot&Stein1998).

(ModiglianiandMiller1958)showhowtocalculatetheoverallcostofcapitalforthe
firmasamarketvalueweightedaverageofthecostsofeachofthecomponentsof
capital used by the firm, both the debt or equity components. It is worthy to
mention that the estimation procedures of both the cost of debt and equity are
generally used to estimate the pretax marginal cost of various sources of banks

funds(Koch&MacDonald2009).Byforcinglinemanagerstoincludetheopportunity
cost of equity and debt when making investment and operating decisions, banks
expecttoelicitbetterdecisionmakingbymanagers(Kimball1998).

Forthecostofdebt,thetraditionalanalysissuggeststhatitisthediscountratethat
equatesthepresentvalueofexpectedinterestandprincipalpaymentswiththenet
proceedstothebankfromtheissue.However,incaseofthelongtermnondeposit
debtthecostofborrowingofeachsourceincludetheinterestexpense,transactions,
servicing,andacquisitioncosts.(Koch&MacDonald2009)

Forthecostofequity,theprevailingformalmethodologyfordeterminingitwasthe
Dividend Growth Model (Lawriwsky 2008). The Dividend Growth Model proposes
that the cost of equity (Ke) is equal to the one year prospective Dividend Yield
(D1/P0) plus the expected growth rate of dividends (g), where D1 and P0 are
respectivelytheprospectivedividendandcurrentshareprice:

Ke=D1/P0+g

Further, the component cost of common stock equity is derived from the Capital
Asset Pricing Model of Sharpe (1964), who proposed that under a set of specific
assumptions,theriskofanyassetisequaltotheriskfreerateofreturnplusarisk
premium,calculatedasfollows:

Ke=Rf+Beta(RmRf)

Where,
Keisthecostofequity
Rfistheriskfreerateofreturn
(RmRf)istheMarketRiskPremium(MRP)
Beta is the assets specific risk premium relative to the market portfolio of
assets.

However, in 1972 Fisher Black proposed a relaxation of the assumption that

investorscanborrowattheriskfreerate.TheresultantBlackCAPMpredictshigher
costsofequityforzeroriskstocksandpredictshigherreturnsonequityforlowbeta
stocks (and lower returns for high beta stocks) than the Sharpe CAPM (Lawriwsky
2008).
Also,(Froot&Stein1998)revisedtheSharpeCAPMbymentioningthat,theuseof
the CAPM assumes away the financing frictions that are central to the model of a
banking firm. And the requiredreturn on equity (cost of equity) contains a second
factorwhenthesefrictionsarepresent:

kN=rF+NM(rMrF)+NPZ

where:
rFistherisklessrate(oftenapproximatedbyaTreasuryyield),

NMistheexposureofthenewprojecttothemarketfactor,
rMistheexpectedreturnonthemarketportfolio,
Zisthebankspriceofunhedgedrisk,
NP = cov (N N, P N)/var(P N); P and N are the risks on the preexisting
portfolioandthenewproject

In words, this second factor boosts by an amount that is proportional to the new
projectsinternalportfoliobeta".

Thissecondbetaisdrivenbythecorrelationofthenewprojectsunhedgeablerisks
with the unhedgeable risks in the banks preexisting portfolio. One of the key
implications of that twofactor model is that a bank should evaluate investments
according to both their correlation with the market portfolio and their correlation
withthebanksexistingportfolio.

The third approach of calculating the cost of equity is the Target Return on Equity
guideline, which is based on the cost of debt plus a premium. Such premium is
requiredtobespecifiedtoshareholdersintermsofreturnonequity.Thatreturnis
thenconvertedtoapretaxequivalentyield.Thismethodiseasy,butitslimitationis
that it assumes the market value of bank equity equals the book value of equity,
whichmeansitisjustbettersuitedforbankswithoutpubliclytradedstock(Koch&
MacDonald2009).

There are several errors characterize the application of this concept like using the
historicalaveragerateofreturn,alongwiththecurrentriskfreerate,inestimating
the market risk premium in the CAPM method. Also, sometimes, the market risk
premium is calculated as the difference between the historical average return on
common stocks and the current return on longterm Treasury bonds, which is also
notcorrect.Anothermistakeisthat,thecostofequityis,sometimes,measuredas
the current dividend rate (dividend per share as a percentage of face value per
share)orasreturnonequity.Onlybyaccidentdothesemeasuresrepresentthecost
of equity correctly. The cost of equity is the rate of return required by equity
investorsgiventherisktheyareexposedto.So,itisnotnecessarilytohaverelation
with the current dividend rate or return on equity, which are mere historical
numbers(Chandra2008).

As a more serious example of miscalculation, (Collier, Graiy, Haslittz, & McGowan

2006) stated that the Cost of Capital Model may provide incorrect answers for
projects that have a level of risk that differs from the overall average risk level for
thecorporationwhenitisusedtocalculatethenetpresentvalueofprojectswithina
multiunit corporation. As a way of correction, they demonstrated the use of the
"Pure Play Method" for calculating the required rate of return for a division of a
corporationthathasriskcharacteristicsthatdifferfromtheriskcharacteristicsofthe
overallcorporation.

Conclusion

Asaconclusion,thecostsoffundsandcapitalarecentralconceptsinbankfinancial
management linking the investment and financing decisions. Accurate cost
measurementofthefinancingoperationscosts,allowsthebanktocompareprices
between alternative funding sources and to assure that assets are priced high
enoughtocovercostsandpayshareholdersarequiredreturn(Koch&MacDonald
2009).Therearedifferentmethodsfortheircalculation.Eachmethodhasitsmerits
over the others. So, each method could be better suited for certain situations and
decisionscases.Understandingthemeritsandlimitations,ofeachmethod,isthekey
oftheappropriateusageandhencemoreefficientfinancialmanagementprocesses
inbanks.

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