Cost-accounting for funding demands careful choices.

Tom Flynn, a hank consultant with Community Banking Concepts, Somerville, N.J.

Key choice is deciding between 'pooling" and "market" methods. One stands out as the clear winner

With the growing popularity of cost accounting and profitability analysis in community banks, the

Because the overall cost of funds in the typical community bank (including both interest and operating costs) often comprises over 80% of the institution's expense, managing this expense is very likely the single most important issue in bank cost-accounting. This is especially true at the departmental level.

With no generally accepted, single, "off-the-shelf" formula in use, banks attempt to set their transfer funds costs using a variety of methods. As a result, peer-performance comparisons are difficult, if not impossible.

Often, the method that a bank finally selects is heavily influenced by its own philosophy of funds management, due to the absence of any industry-accepted standard. Even allowing for philosophical differences, however, I believe community banks need to consider the impact that their choice of method can have on planning efforts. I will examine two common methods and demonstrate why I believe one of them is a better option.

The pool-pricing method

The first step to determine funding cost is to compute its actual internal costs to generate funds. Often the data to generate this information are readily available in general ledger records, though digging is sometimes required. This produces your bank's true "inventory" costs (after all, what bankers typically sell is the use of sums of money) on an ongoing basis.

This is commonly referred to as the bank's internal, or "pool," cost of funds. In the process of computing the cost, the bank's total funds lose their individual identity, as all funds and their related costs enter the general pool of available funds. The total costs associated with the pool, both interest and administrative, are totaled, creating the overall costs of obtaining, maintaining, and servicing the bank's pool of available funds.

Typically, in cost accounting, such "inventory" costs are computed on an ongoing basis, consistently providing the latest inventory cost. In a typical community bank, this includes the expenses of operating the branch network, and all support functions that service the bank's deposit base.

Once the internal pool cost of funds is determined, the process of transferring the cost from suppliers to users is structured. The "earning asset" departments normally comprise the bulk of fund users. "Non-earning" assets (fixed assets, vault cash, etc.) comprise the balance. Typically, non-earning assets total about 5% to 7% of total assets, with the balance fully invested in the earning-asset portfolios.

Categorizing departments as funds users or funds suppliers can be challenging, as often a community bank may opt to have some of its loan portfolio carried in branch offices, thus making those offices both users and suppliers of funds. While this practice is quite common, it can be misleading, particularly in the process of determining total costs of a specific loan function to compute the "break-even" interest rate. With significant loans assigned to branch offices, capturing all specific loan function costs can be difficult. A common approach to this challenge is to credit the branch offices with only those loan assets that they actually control--perhaps consumer loans up to a specific size; the remainder of the loans are centralized in the loan department that actually administers the portfolio.

Using the bank's ongoing pool cost as the transfer (from providers to users), price is the ideal performance comparison for the branch offices. Using the average of all branches as the benchmark, all branch offices compete to "beat the average," often generating steadily increasing overall performance.

The market-pricing method

The transfer of funds costs using "market"-oriented rates is commonly referred to as "market" transfer pricing. This theory essentially rewards suppliers of funds at the market rate for generating funds at less-than-market costs. In doing so, it conversely charges fund users at these market-oriented rates. In essence, the funds supplier is being credited--and the funds user charged at--the open-market cost to generate funds inventory. This is as opposed to the supplier receiving and the user paying the actual costs within the bank.

This approach essentially "transfers" income from one side of the balance sheet to the other. As it rewards the fund suppliers at a markup over their actual cost to generate funds, this approach penalizes the fund users (earning asset departments) by charging for funds at this market cost.

The difference between cost and market is often referred to as the "competitive advantage" (i.e., at how much less cost the branch network can generate funds when compared with the open market cost to purchase similar funds).

Why use this method? Backers point out that using market pricing challenges earning asset departments to price their products at a level sufficient to absorb the "market" funds costs, plus departmental overhead. While various market sources can be applied, the most popular is probably the Treasury yield curve.

A natural question here: Is this method appropriate for community banks? After all, critics will argue, the typical community bank is often competing with other community banks for local deposits, such that all bank competitors for the local dollar acquire the vast majority of their funds through branch deposits, and little, if any, through open market purchases.

The obvious question is, who are we competing with? The market pricing model is appropriate for commercial finance, leasing, and consumer finance companies because all the funds they use are purchased in the open market, The pricing in these businesses is traditionally and necessarily higher, as they purchase all funds on the open market. Not so in community banking.

Obviously, pricing the earning asset products by using market cost of funds in place of your actual cost will result in a noticeably higher "break-even" price--very often high enough to put your lending products out of the market, as compared with your competitors. The word of caution here is that while market transfer pricing may be good information in specific cases, extreme care should be used in applying it to product pricing strategy. Using an external market figure in place of your own costs to valuate your inventory appears quite contrary to basic costing standards.

Another word of caution in using market funds rates rather than your actual funds costs is that the market basis tends to reward the branch offices with higher funds costs-not quite the result you may want to see.

Because three-year funds cost more than one-year funds, the branch that adds a three-year CD to its portfolio will receive a higher funds credit than it would get for a one-year CD. Essentially, so long as an astute branch manager can maintain his overhead at a set level, he can "book" all the high-cost deposits he can attract, and gradually increase his branch's profits.

Managing branch deposit mix and interest expense can therefore be much more challenging (and costly!) under the market pricing method. Also, the results of market transfer pricing on the earning asset departments can be quite significant-often showing a loss on a specific portfolio, which in reality may be quite profitable on a true cost basis.

Making the choice

Equipped with the proper tools--a good departmental cost--accounting system and a solid understanding of your competitive market area--the funds transfer credit choice becomes easier.

Said simply, "pool" funds costs are "what is." Market basis costs are "what if." In the competitive world of community banking, I submit that choosing "what is" makes more sense.

Trying different approaches and viewing their results remains a very helpful exercise. However, bear in mind that when you decide on the correct approach or your bank, stick with it. As with any other major area in cost accounting, consistency is paramount.