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What is the Cost of Funds?

Synopsis:
 

The cost of funds means the interest expense paid by banks and other financial institutions on the money they borrow.Read more..It is important for such institutions to keep their cost of funds low to remain competitive in the market. For example, if a bank has to pay a high cost of funds, it will find it tough to provide loans to its customers at an affordable interest rate. Hence, the cost of funds is an extremely important metric in the financial industry.Read less


“Cost of funds” is an important concept in the banking and finance industry. Financial institutions have to raise funds to lend money to borrowers. The cost of funds means the amount paid by such institutions on the funds they borrow.

Financial institutions can borrow or raise money from a variety of sources. For example, banks have access to their customers' savings and current accounts. They use the money deposited by their accountholders to lend to their clients.

Banks can also borrow from other banks to lend to their customers. Moreover, they can issue bonds to raise money in order to lend to their borrowers. The interest paid on money raised from these sources is known as the cost of funds. Having discussed what the cost of funds is, let us dig deeper into this topic.

Importance of Understanding Cost of Funds

Whether you are an investor or an analyst, it is extremely important to understand the cost of funds. All financial institutions borrow money to lend to their customers. When their cost of funds increases considerably, it can affect their profitability.

Financial institutions like banks, non-banking financial companies (NBFCs), and others lend money to their customers at a higher rate than the rate at which they borrow money. The difference between the rate at which they borrow and the rate at which they lend is called the spread.

If a bank’s cost of funds is high, it is very likely that it will also lend at a high rate. Otherwise, its spread will fall or it may even make losses. Hence, a high cost of funds impacts both: the institution that raises funds and its borrowers.

Besides, when a financial institution’s cost of funds is excessively high, there could be a serious reason behind it. For example, it could be that its management is not efficient or it is not able to recover the loans it provides, resulting in non-performing assets (NPAs). So, in such cases, it becomes imperative for you to analyse why an institution is paying an excessively high cost of funds.

How to Calculate the Cost of Funds

To calculate the cost of funds, you need to divide the total interest expense of a financial institution for a period by the average balance of its borrowed funds for that period.

You can calculate the average balance by finding the average of the opening balance and the closing balance of borrowed funds for a period. Let us say that a bank has ₹ 1 crore worth of borrowed funds on April 1, 2024 and ₹ 1.5 crore as borrowed funds on March 31, 2025.

So, for the FY 2024-25, its average borrowed funds is the average of ₹ 1 crore and ₹ 1.5 crore, which is ₹ 1.25 crore. Suppose, the bank pays ₹ 5 lakh as interest expense in FY 2024-25. Its cost of funds is 4% (₹ 5 lakh / ₹ 1.25 crore).

Factors Influencing the Cost of Funds

Understanding the cost of funds is not complete without knowing the factors that impact it. So, here are the factors that impact the cost of funds:

  1. Economic scenario: The cost of funds is affected by the economic parameters of a country, like the current and expected inflation rate, the interest rates set by the central bank, the overall mood in the country, etc. For example, if inflation is expected to increase, it suggests that the value of money will deteriorate, which can cause the cost of funds to increase.

  2. Reputation and creditworthiness of an institution: A financial institution’s creditworthiness and reputation affect its cost of funds. If lenders think that a bank cannot repay funds on time, they may either not lend to it or charge an extremely high rate of interest to provide funds.

  3. Competition for funds: If there is a lot of competition for funds to borrow, financial institutions may have to offer a high rate of interest to raise finance. Conversely, when the competition for funds is not much, they may raise funds at a low interest rate.

  4. Type of source: The cost of funds is also a function of the nature of the source. For example, banks pay a much higher interest rate on fixed deposits (FDs) than on savings accounts.

Cost of Funds vs. Cost of Capital

Cost of funds and cost of capital may sound similar, but they are profoundly different concepts. Cost of funds is used mostly in the context of financial institutions to represent the interest they pay on borrowed funds. For example, a bank pays an interest expense on FDs, current & savings accounts, bonds, etc. The essential point is cost of funds represents the money paid on borrowed funds.

On the other hand, the cost of capital is the cost paid by a company on funds raised through equity and debt both. In other words, the cost of capital represents the return a company must generate for investors to invest in its debt and equity. As the cost of capital considers equity and debt both, it is a broader measure than the cost of funds.

Impact of Cost of Funds on Lending Rates

A financial institution’s cost of funds has a direct impact on its lending rate. Let us say a bank has to pay a high cost of funds to borrow funds. How will it recover the excess cost of funds?

Obviously, it will have to increase the interest rate at which it provides funds to its borrowers. That said, it may or may not be possible for it to increase its lending rate by the percentage at which its cost of funds has increased.

Meanwhile, if the cost of funds falls, a bank may reduce its lending rate as well, thereby benefiting its borrowers. Whether or not it will actually reduce its lending rate depends upon many factors. For example, if its competitors are reducing their lending rate, it too can follow suit. However, if its competitors are reluctant to reduce their lending rate, it may also not reduce its rate much.

Strategies for Managing Cost of Funds

If an institution wants to effectively manage its cost of funds, it can follow these strategies:

  1. Raise funds from a variety of sources: An institution needs to have diverse sources to raise funds to manage its costs. Excess reliance on one or two sources may increase its cost of funds. Hence, diversification is the key here.

  2. Attract low-cost deposits: A bank pays a much lower interest rate on current & savings accounts than it pays on FDs. Hence, it should mobilise more low-cost deposits to lower its overall cost of funds. If it relies too much on high-cost FDs, it may increase its cost of funds.

  3. Efficient asset-liability management: Financial institutions need to strike a balance between the duration of their assets and that of their liabilities to manage their cost of funds well. For example, they should match long-term loans with long-term sources of funds and short-term loans with short-term sources of funds.

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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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