What Is the Net Interest Rate Spread?
The net interest rate spread is the difference between the average yield that a financial institution receives from loans, along with other interest-accruing activities, and the average rate it pays on deposits and borrowings. The net interest rate spread is a key determinant of a financial institution's profitability (or lack thereof).
Most commercial banks (such as savings and loans) generate their main source of profits through the interest rate spread, where they pay interest to depositors at a lower rate than that which they extend to borrowers in loan interest. For instance, they may credit depositors 1.25% on their money while issuing a mortgage to a home buyer charging 4.75%. In this case, the net interest rate spread would be 3.5%, minus any fees or costs incurred by the bank in effecting both transactions.
The Net Interest Rate Spread Explained
The primary business of a bank is managing the spread between deposits that it pays consumers and the rate it receives from their loans. In other words, when the interest that a bank earns from loans is greater than the interest it pays on deposits, it generates income from the interest rate spread. The size of this spread is a major determinant of the profit generated by a bank. Although we won't delve into how rates are determined in the market, several factors drive rates including monetary policy set by the Federal Reserve Bank and the yields on U.S. Treasuries.
In simple terms, the net interest spread is like a profit margin. The greater the spread, the more profitable the financial institution is likely to be; the lower the spread, the less profitable the institution is likely to be. While the federal funds rate plays a large role in determining the rate at which an institution lends immediate funds, open market activities ultimately shape the rate spread.
Loan-granting institutions, such as commercial banks, receive interest income from a range of sources. Deposits (often called core deposits) are a primary source, generally in the forms of checking and savings accounts or certificates of deposit (CDs). These are often obtained at low rates. Banks also obtain funds through shareholder equity, wholesale deposits, and debt issuance. Banks issue a variety of loans, such as mortgages on property, home equity lending, student loans, car loans, and credit card lending that are offered at higher interest rates.
Net Interest Spread and the Federal Funds Rate
As noted above, while open market activities are key to determining the net interest spread, the federal (“fed”) funds rate, is a core component. According to the U.S. Federal Reserve, the federal funds rate is “the interest rate at which depository institutions lend reserve balances to other depository institutions overnight.”
This applies to the biggest, most credit-worthy institutions as they maintain the mandated amount of reserve required. Thus, the fed funds rate is a base interest rate, by which all other interest rates in the U.S. are determined. The fed funds rate is a key indicator of the health of the U.S. economy.