Silver Bullet for Margin Compression
Cost of funds is the king of retail banking acronyms. Yet, it only tells us half the story. Granted, without a sharp eye on COF, credit unions can expose themselves to devastating interest rate risk. As recent years have shown us, net interest margins can compress very quickly — and stay compressed much longer than anyone previously expected — revealing how little control we have over our mixed asset yield. Fortunately, we can still influence overall deposit cost and take back a large portion of our margin control.
COF falls incredibly short, though, when assessing the true cost for the core component of any member’s relationship with their credit union — their checking account. To illustrate, high-yield checking accounts average $5.90 in monthly interest expense, or a COF of 0.79%. But a more holistic measurement of those same accounts reveals they actually generate an average of $6.20 net profit. That’s nearly $75 in annual profit per account, before even considering the interest income generated by redeploying the deposits.
Clearly, basing strategic funding decisions on COF alone is like driving with blinders on, leaving you in danger of making a costly mistake.
A New Acronym — And A New Revenue Stream
Cost of funds works well for many deposit products like savings, money markets, CDs. But not transaction accounts. COF captures interest expense. But transaction accounts also have noninterest expenses and income, which can easily get buried in the balance sheet and not properly associated with these deposits.
Consider free checking. While it has a 0% COF, there are a number of marginal expenses — processing checks, sending statements, core fees and more. But there’s also debit card interchange and overdraft revenue. When you look at this whole picture — interest expense, noninterest expense and noninterest income — you’re now looking beyond COF, and seeing the holistic view of the cost of deposit, or COD.
A lot of revenue and expense flows through free checking that never impacts the 0% COF. Unfortunately, many credit unions have little visibility to these numbers as a function of the individual account type, because they’re tracked en masse across the entire deposit suite. This makes it virtually impossible to assign marginal expenses and revenue to individual product types.
Now is the time to make accurately measuring the full story — the cost of deposit — a priority. Mired in continuing margin compression at historic levels, there are only so many options available for responding:
- Increase interest revenue. Regrettably, there simply isn’t enough loan demand to go around.
- Decrease interest expense. Financial institutions are reporting their lowest COF in recent history, suggesting there’s little room for more cuts.
- Decrease noninterest expense. Most financial institutions have squeezed just about every drop available here too.
- Increase noninterest revenue: Traditionally, this has meant higher fees or other strategies that draw intense consumer ire. But, it doesn’t have to be that way.
Next Page: Cost of Deposit
Using COD to Position Your CU for Growth
Through the holistic cost of deposit lens, we accurately allocate noninterest expenses and revenues to the accounts generating them. As a result, the true value of transaction accounts as a lower cost/higher margin source of funding becomes apparent. We then see the liabilities of certain deposit accounts are actually valuable revenue streams.
An increasingly popular method to maximize that revenue has emerged over the past decade: qualification-based, high-yield checking accounts. They’re attractive to consumers by adding potentially high dividends on top of free checking. The attraction for credit unions has also been validated. These reward accounts attract desirable consumers who are twice as likely to take out a loan in their first year, and who utilize 33% more of your products per household.
As for COD, reward accounts have been proven to both increase revenue while decreasing expenses. A nationally branded high-yield reward checking account that is offered by well over 200 community financial institutions provides a lot of performance metrics. On average, those high-yield accounts have the following impacts on community financial institutions nationwide:
- Generate a 45% increase in non-interest income.
- Lead to nearly 80% e-statement adoption, reducing overall statement expense by 69%
- More than 2X debit card swipes per account and interchange revenue
Most telling, what appeared as 0.79% COF is actually revealed as -2.04% COD, meaning these deposits generated a 2.04% profit margin, before they were invested or loaned. The bottom line … is your bottom line. No matter your particular situation or opinion on market compression, accurate tracking to obtain the lowest possible cost of deposits will always be in the best interest of your credit union.
Of course, the lowest COD will typically be free checking. But the extraordinarily high attrition rate and extraordinarily low life expectancy of free checking begin to cancel out any COD advantage it has. Reward checking accounts, however, retain the exceptional benefit of a low-cost deposit source — along with key advantages like more loans, more wallet share and more noninterest income.