What Factors Affect Bank Cost of Capital?

K. Kinsella

Banks fund lending with capital that is raised from shareholders, investors, central banks and other lending institutions. A number of different factors can affect the bank cost of capital and these include fiscal policy decisions, stock market fluctuations and changes in the bank's loan default rate. When capital costs rise, banks tighten underwriting standards and consumer and business loans become more expensive. The opposite occurs when capital costs decrease, although rapidly falling capital costs can eventually cause inflation since the supply of money outstrips the demand.

In many areas around the world, commercial banks borrow money from government-operated central banks.
In many areas around the world, commercial banks borrow money from government-operated central banks.

In many areas around the world, commercial banks borrow money from government-operated central banks. Typically, government officials are responsible for setting the interest rates on these intra-bank loans. During recessions, central banks often drop interest rates so as to make it less expensive for banks to borrow money. Low interest rates are normally passed onto consumers and as cheap credit becomes freely available, spending increases and the economy normally starts to emerge from the recession. Therefore, government policy makers have a direct role in determining the average bank cost of capital.

Aside from borrowing money from central banks and other institutions, banks also raise funds by selling shares. The capital infusions raised during share offerings are often used to fund the writing of new loans. As with other types of stocks, shares in banks tend to lose value during market downturns and rise in value during stock market booms. Negative press involving the financial performance of a particular institution can also have a direct impact on that firm's ability to raise capital through share offerings. Consequently, executives who attempt to make long-term bank cost of capital predictions have to factor both fiscal policy decisions and stock market fluctuations into the equation.

Most banks offer a variety of deposit accounts and in most countries, banks are able to use some of these deposited sums of money to fund loans. Since banks have to compete for deposit customers, interest rates on bank accounts at one institution are impacted by the interest rates offered by that bank's competitors. An institution may have to raise its deposit rates in order to fend off competition from other banks but bank cost of capital expenditure increases whenever interest rates are raised on deposit accounts.

In some nations, banks are required to insure deposited funds. Banks pay deposit insurance premiums that are based upon the size of the bank's deposit base and the institution's financial strength. If a bank begins to experience financial problems its deposit insurance costs rise. This means it becomes more expensive for that bank to raise capital through selling deposit accounts. In such situations, a bank may opt to sell shares or to borrow money from the central bank since insurance premiums are only assessed on funds borrowed from account holders.

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