FIG Experts: What percent of a bank's cost of capital is determined by the 'discount rate'?

FIG experts: the idea is that the Fed raises the overnight borrowing discount rate. This raises the cost of capital of a bank. The bank then charges their Borrowers a higher interest rate. Right?

Problem is, the bank's cost of capital is ACTUALLY determined by what they have to pay their Depositors, right? And that has nothing to do with the discount rate.

Is the discount rate really a big deal in comparison to the global chase for yield, as foreign money sloshes into treasuries and other ‘safe’ debt instruments, further compressing yields in the fixed-income space?

 

By cost of capital, are you referring to WACC or cost of funding? Those are two different things in the context of a bank.

If the former, it'd be determined by the whatever the weighted average yield of the outstanding debt plus some hypothetical number for the cost of equity (e.g. CAPM). As it relates to the discount rate, a low benchmark rate brings down the cost of debt capital for pretty much everybody in the economy, so yes, banks do benefit from this. Theoretically, this may raise the cost of equity if a bank is very asset sensitive and rates continually fail to go up, but that's not observable and can only be estimated (with poor accuracy I might add).

If you mean the latter, just look at the bank's average balance sheet and look at the liabilities section and the weighted cost. This gives you the weighted average cost of funding. In a rising rate environment, you'd assume some balance sheet mix shift depending on the funding base (e.g. Wholesale funding vs retail deposits), and a general rise in the cost of deposits, which would theoretically be offset by an increased interest rate charged to borrowers.

In answering your overall question as to whether this is a 'big deal', the short answer is yes. This is literally why FIG ER analysts have jobs - trying to quantify the impact in the short and long term and understanding whether the business models as they exist now still make sense.

If you'd like a clearer answer, please qualify what 'cost of capital' metric you're referring to.

 
Braininajar:
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If you mean the latter, just look at the bank's average balance sheet and look at the liabilities section and the weighted cost. This gives you the weighted average cost of funding. In a rising rate environment, you'd assume some balance sheet mix shift depending on the funding base (e.g. Wholesale funding vs retail deposits), and a general rise in the cost of deposits, which would theoretically be offset by an increased interest rate charged to borrowers.

In answering your overall question as to whether this is a 'big deal', the short answer is yes. This is literally why FIG ER analysts have jobs - trying to quantify the impact in the short and long term and understanding whether the business models as they exist now still make sense.

If you'd like a clearer answer, please qualify what 'cost of capital' metric you're referring to.

I'm thinking big picture here. Fed raises discount rate, rates go up in the US (so yes, I mean the latter, cost of funding .... that it was obvious when I said "charges borrowers a higher rate"). Not a single person (and that includes you) I've spoken to can explain the nonsensical fluff that we're fed in the classroom (and that the sheep on CNBC talk about) when it comes to this belief that the fed can magically raise yields.

Let's look at US Bank's balance sheet. About 90% of their liabilities are NOT short-term.

And guess what! Over 95% of the AVERAGE FOR THE YEAR short-term liabilities are NOT federal funds! Do you really need to keep dancing around the obvious here?

It is hilarious that you lemmings sit around talking about the Fed being able to increase yields in the US. Debt is global. We borrow money from foreigners. If the Fed wants to charge more, whoop-de-fucking-doo ... I'll just go borrow it from Europe or Asia. The Fed does not control the cost of funding, the cost of money - sorry if you were under that comforting impression.

 
Best Response

I mean, you're entitled to your interpretation. Not really sure what's the point of ad hominem attacks.

With respect to cost of capital phrasing, I'm guessing you're more from a generalist background? No FIG analyst I've ever spoken to refers to bank funding costs as cost of capital so it was pretty weird to see that.

As to why the fed funds rate would have an impact on cost of funds for a bank, it's because the benchmark rate reflects the local cost of borrowing. Besides the legal entity issues, borrowing in a foreign currency to fund local operations exposes a bank to significant currency risks that cost money to hedge. This is a can of worms that a lot of banks wouldn't want to deal with. (Indeed this applies to corporates in general that wouldn't want to deal with the risks involved with funding operations from cheaper, foreign localities).

In the case of your example, you've provided one isolated example of one bank as to its overall funding structure. Regardless, it's not just the maturity structure of the liabilities but what actually makes up the funding base (e.g. Wholesale vs deposits).

In the case of deposits, these are a huge source of funding for banks, both large and small, and a raise in the fed funds rate would improve the competitive advantage of money market funds which would in turn force banks to raise interest rates to retain less sticky deposits. Obviously there's uncertainty as to how much of a single 25 bp hike would accrue to deposit holders, but with subsequent rises in the rate, more and more of it would. In any event, in prior periods, this has been observed when the benchmark rate was hiked in a meaningful way.

Lastly, for those unfamiliar with the intricacies of bank regulation, regulators around the globe are trying to reduce liquidity risk by reducing reliance on wholesale funding through things such as NSFR and LCR. These new regulatory regimes heavily penalize reliance on wholesale funding while implicitly supporting the use of retail deposits. Right or wrong, this is the new environment banks need to deal with and even broker models such as Goldman Sachs are now branching into retail to satisfy these regulatory needs. That's pretty much the whole reason why GS Bank is a thing where anyone can open an account. This provides empirical evidence that banks will not simply borrow from lower yielding localities because if it were so simple, GS wouldn't be paying one of the highest retail deposit rates in the country.

Having said all that, I imagine the fed funds rate will remain lower for longer, but you can bet your bottom dollar that if rates were raised significantly (150+ bps in the aggregate) that yields will go up in the US.

Happy to go into more detail if you're interested.

 

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