What Is the Pooled Cost of Funds?
The pooled cost of funds is a method used to determine the total cost of funds, or the expense incurred by banks and other financial institutions (FIs), to take deposits and make loans.
The cost of funds is one of the most important input costs for a financial institution since a lower cost will end up generating better returns when the funds are used for short-term and long-term loans to borrowers.
- The pooled cost of funds measures the total expense incurred by banks to take deposits and make loans.
- To earn a profit, the interest charged on loans made must exceed the rate paid to depositors.
- The pooled cost of funds is one of several profitability metrics used to evaluate banks and other lending institutions.
Understanding the Pooled Cost of Funds
Like any other company, banks need funding available to finance their business activities. Commercial banks mainly make money by borrowing from other FIs or customers who deposit money with them and then using this capital to provide loans to households and companies at a higher rate of interest. In order for this business model to be sustainable, the interest rate banks charge on such loans must be greater than the interest rate they pay to obtain the funds initially, which is their cost of funds.
The pooled cost of funds is one method designed to establish if businesses are succeeding in this goal by creating enough profits. This accounting formula requires looking at the institution's assets, the bank’s use of funds, its liabilities, and its sources of funds as a whole via its balance sheet.
The pooled cost of funds is determined by dividing the balance sheet into several different categories of specific interest-earning assets. These assets are then pitted against corresponding interest-sensitive liabilities.
The pooled cost of funds often matches assets and liabilities with similar or identical time horizons. It also charges debits and credits to the assets and liabilities, depending on the income they are earning or it is costing. This formula is generally adjusted for the legal reserves that banks are required to keep as a percentage of their deposits.
Benefits of Pooled Cost of Funds
Determining a bank’s costs of funds by pooling them together is important for several reasons. The spread between the cost of funds and the interest rate charged to borrowers represents one of the main sources of profit for many FIs.
Banks are an important pillar of the economy, so their success can have much greater implications for the economy. When FIs choose to absorb extra funding costs, their profits fall and they risk becoming insolvent. Unhealthy banks, like what occurred during the Great Recession, aren’t good for savers, business, or consumers and can effectively derail economies.
Likewise, economic growth tends to contract when banks opt to significantly increase the amount they charge for loans to reflect their rising costs of funding. Higher lending costs increase the probability that borrowers won’t be able to repay their outstanding debts. A dearth of affordable loans also usually results in lower consumer spending, investment, and overall economic activity.