Whatever difference a bank incurs when its income is subtracted from its assets that bear interest, alongside the costs used to satisfy the liabilities that bear interest.
The difference between such revenue and cost is called net interest. Banks have various assets that can generate income. Examples are:
Car loans
Personal loans
Mortgages
Commercial real estate
Whenever we pay interest on products above, it serves as the revenue to the bank. Also, banks pay customers interest as an incentive to keep money in their savings accounts. This difference also helps in profit calculation for banks. As a result, when interest rates rise, banks thrive but the opposite hurt them.
Origin of Net Interest Income
Some banks have net interest as their primary income source. Their revenue comes from assets that bear interest. This explains why many banks have the following products:
Credit cards
Auto loans
Student loans
Personal loans.
These financial products all generate interest. As a result, taking out a car loan at 15% interest to borrow $30,000 rewards the bank with the interest. It is their fee for loaning people the money. As expected, the more the rate, the more revenue they generate. However, there is also a possibility of losing money should they lend to a borrower who defaults.
Also, a deposit at the bank might generate interest like a 3% rate. Now the difference between the 15% and 3% interest is the revenue that the bank generates.
A reliable way to determine the bank’s success is to access the loan portfolio quality. The net interest income of a bank is a factor of the asset and its loan portfolio mix.
Ideally, the loan portfolio will be a combination of variable and fixed rate loan. This is also a factor of the customers’ credit quality.
Significance of Net Interest Income
Net interest income serves as a measure of financial performance for many banks. When interest grows, net interest margins increase, and the reverse holds.
It helps understand the loan portfolio’s quality, the effect of the interest rate’s changes on the profitability of the bank, etc.
Understanding Net interest income gives insight into the financial health of the bank for investors who would like to invest in bank stocks.
Net interest income is also affected by the non performing assets of a bank. As a result, net interest income helps evaluate the banks’ assets quality.
Net Interest Margin
Net interest margin is the money a bank earns on loan interest, compared to what the bank pays as interest on various deposits. This tool is a measure of the profitability and growth of the bank.
Many lenders with interest assets like banks, and various financial institutions see this as a profitability ratio for industry.
Net Interest Margin = [Interest Revenue – Interest Expense] / Average Earning Assets
Average earning assets simply involve finding the average of the balance of the beginning and ending asset.
When the interest rate increases in the economy, there is an impressive net interest margin. Also, when interest rate decreases, there is a lower net interest rate margin.
Finally, when the net interest margin is positive, it is a pointer that the bank is investing its assets and capital well. In the same way, a negative value of the net interest margin points to various poor decisions by the bank.
Factors Affecting Net Interest Income
Variable rates on liabilities and assets are usually affected when there is a change in the interest rate. As a result, it can affect and trigger various changes on the net interest income.
Non-performing assets of banks also influence the net interest income.
When the gap between the asset rate and liabilities rises, there is a corresponding rise in the interest income which boosts the net interest income value.
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