Managing the cost of funds is crucial for effective risk management and diversifying funding sources. — The Jakarta Post
IN the banking industry, profitability and operational efficiency are crucial for sustained success, and a key aspect of banking operations that significantly impacts profitability is cost of funds.
Cost of funds measures the price at which a financial institution acquires money from various sources, such as depositors, shareholders and other borrowing mechanisms.
The cost of funds directly affects a bank’s profitability.
Banks earn income by lending money at interest rates higher than the cost of the funds used to acquire those assets.
Lowering the cost of funds allows banks to maintain high net interest margins, enhancing profitability in a highly competitive industry. Consequently, optimising the cost of funds is crucial for banks to improve their bottom line and financial stability.
A lower cost of funds allows banks to offer more competitive interest rates on loans and other financial products.
Banks can then attract more customers, leading to an increase in the deposit base and a higher lending capacity. This competitive advantage helps banks retain existing customers and attract new ones, strengthening their market position in the industry.
According to the Integrated Banking Financial Report, third-party funds grew significantly slower as of October 2023 at 3.43% year-on-year (y-o-y).
The slowdown is heavily influenced by a shift in public investment to securities, particularly government bonds (SBNs), rather than savings or time deposits.
According to the data from the Integrated Bankin Financial Report, SBNs have shown a slower growth trend of 10.28% y-o-y as of October 2023.
This decrease was also caused by a decrease toward the end of the year in corporate demand deposits, especially for state-owned companies. Therefore, increasing the interest rates on funds is an alternative strategy to strengthen intermediation capacity, one of which is by providing special rates to customers.
This is confirmed through the share of time deposits exceeding two billion rupiah, for which the special interest rate has increased from 18.69% in July 2023 to 62.98% in October 2023.
This increase specifically occurred at rural banks and private national banks.
By offering competitive interest rates on deposits, banks can attract more funds, stimulating intermediation and enabling increased lending. Special interest rates on bank deposits act as a tool to incentivise depositors to save with commercial banks, rather than alternative financial institutions or non-bank entities.
An increase in deposit interest rates through special rates is a preemptive step banks can take to minimise the transmission impact of policy interest rate increases on bank credit interest rates.
The increase in the BI seven-day reverse repo rate from 5.75% to 6% in October 2023 generally led to higher borrowing costs for commercial banks, making them more cautious when extending loans to individuals and businesses.
In the short run however, it is unlikely to have a significant impact due to the abundant liquidity in the banking sector and the less responsive nature of the rate of the Deposit Insurance Corporation (LPS).
This is demonstrated by the Liquid Assets to Third-Party Funds ratio, which stood at 26.36% as of October 2023, far above the 10% threshold.
Additionally, the LPS rate was just raised in early 2023 in response to global and domestic economic uncertainty at the time.
Furthermore, banks should embrace the potential opportunities that arise from an increase in credit interest rates. While it may temporarily slow down the growth rate of banking credit, it also opens doors for banks to diversify their income sources in their business operations.
Banks can explore and implement alternative strategies to mobilide funds and invest in the vibrant rupiah and foreign money markets, or in lucrative securities like Sekuritas Rupiah Bank Indonesia, Sekuritas Valas Bank Indonesia, and Sukuk Valas Bank Indonesia.
In addition to these options, banks can also forge partnerships with larger banks to seize the benefits of syndicated loans. This collaborative approach can provide banks with access to a broader range of customers and expand their lending capabilities. In addition, existing customers with proven track records present an excellent opportunity for banks to extend corporate loans, fostering stronger relationships and driving mutual growth.
Risk exposure
Moreover, managing the cost of funds is essential for banks to effectively balance their risk exposure.
By diversifying funding sources and managing the cost of funds, banks reduce their reliance on a single funding source. This diversification aids in mitigating risks associated with interest rate fluctuations and funding market instability.
Banks can swiftly adapt to changing market conditions by optimising their cost of funds, thereby enhancing their risk management capabilities.
Furthermore, several factors should be considered to maximize the effectiveness of special interest rates on banking deposits for strengthening intermediation capacity.
These include the transparency and predictability of interest rate policies, efficient payment systems, developing financial literacy among the general population, and ensuring a stable and sound banking system that instills trust and confidence in depositors.
Besides, the LPS plays an essential role in maintaining public confidence in the banking system by providing deposit insurance.
LPS guarantee rates determine the extent of coverage should a bank fail. A close relationship exists between the special interest rates offered by banks and LPS guarantee rates.
Banks adjust their interest rates to reflect the costs associated with deposit insurance premiums, ensuring a fair return for depositors while accounting for potential risks.
Competitive rates
Finally, the cost of funds significantly impacts a bank’s profitability and can be optimised by offering competitive interest rates on deposits.
Increasing deposit interest rates will help to attract more funds and stimulate lending, strengthening a bank’s intermediation capacity.
Managing the cost of funds is crucial for effective risk management and diversifying funding sources.
Factors for maximised effectiveness include transparent interest rate policies, efficient payment systems, financial literacy development and a stable banking system, while LPS guarantee rates play a role in determining the special interest rates offered by banks to account for potential risks. — The Jakarta Post/ANN
Darmo Wicaksono is a senior economist with the international department at Bank Indonesia. The views expressed here are the writer’s own.
