What Is Net Interest Margin?

Net interest margin is a ratio that measures how successful a firm is at investing its funds in comparison to its expenses on the same investments. A negative value denotes that the firm has not made an optimal investment decision because interest expenses exceed the amount of returns generated by investments.

Net interest margin is expressed a percentage. It is one of the profitability indicators of an organization, showing how much it earns on interest from its credit products—loans, mortgages—compared to the interest it pays out on things like savings accounts and certificates of deposit (CDs).

How Net Interest Margin Works

Net interest margin is typically used for a bank or investment firm that invests depositors' money, allowing for an interest margin between what is paid to the bank’s client and what is made from the borrower of the funds.

A positive net interest margin indicates an entity invests its funds efficiently, while a negative return implies the bank or investment firm doesn't invest efficiently. In a negative net interest margin scenario, the company is better served by applying the investment funds toward outstanding debt or utilizing the funds for more profitable revenue streams.

Net interest margin is a profitability indicator investors really need to understand before they make certain investments. Here's a way to simplify the concept of net interest margin. Banks lend money to customers. That capital comes from from money from people making deposits, other lenders, and shareholders. They earn money from the interest on those loans, which is offset by the interest they pay to consumers with savings accounts. If a bank consistently has a negative net interest margin, investors may want to steer clear because it lends more than it makes in interest. All the figures needed to calculate an institution's net interest margin can be found in its financial statements.

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Net Interest Margin

Calculating Net Interest Margin

Net interest margin is calculated as:

Net Interest Margin

Let's use this formula to calculate the net interest margin for a fictional company. Assume ABC Corp has a return on investment of $1,000,000, an interest expense of $2,000,000, and average earning assets of $10,000,000. ABC Corp's net interest margin totals -10%. This reflects the fact that ABC Corp lost more money due to interest expenses than it earned from investments. ABC Corp would fare better if it uses the investment funds to pay off debts rather than to make this investment.

Key Takeaways

  • Net interest margin is a profitability metric that measures how much a bank earns in interest compared to how much it pays out to consumers.
  • It is typically used for a bank or investment firm that invests depositors' money.
  • A positive net interest margin indicates a bank invests efficiently, while a negative return implies it doesn't invest efficiently.
  • Net interest margin can be calculated by subtracting interest expenses from interest income, then dividing that figure by the average earning assets.

What Affects Net Interest Margin

There are several factors that affect a financial institution's net interest margin. First, is supply and demand. If there is a large demand for savings accounts compared to loans, net interest margin decreases, as the bank is required to pay out more interest than it receives. Conversely, a higher demand in loans versus savings accounts—more consumers are borrowing than saving—means a bank's net interest margin increases.

Monetary policy and fiscal regulation can impact a bank's net interest margin as the direction of interest rates dictate whether consumers borrow or save.

Monetary policy and regulations set by central banks also have an influence on the net interest margins of banks, because they play a role in demand for savings and credit. When interest rates are low, consumers are more likely to borrow and less likely to save. This generally results in higher net interest margins. But if they raise rates, loans become more expensive, making savings more attractive, thus, decreasing net interest margins.

Net Interest Margin and Retail Banking

Net interest margin is well explained by illustrating how a retail bank earns interest from customer deposits. Most banks offer interest on customer deposits, generally in the range of 1% annually. The retail bank, at that point, turns around and lends an aggregate of multiple clients’ deposits as a loan to small business clients at an annual interest rate of 5%. The margin between these two amounts is considered the net interest spread. In this case, it works out to an even 4% spread between the cost of borrowing the funds from bank customers and the value of interest earned by loaning it out to other clients.

Net interest margin adds another dimension to the net interest spread by basing the ratio over its entire asset base. Let's say a bank has earning assets of $1.2 million, $1 million in deposits with a 1% annual interest to depositors, and loans out $900,000 at an interest of 5%. This means its investment returns total $45,000 and its interest expenses are $10,000. Using the formula above, the bank's net interest margin is 2.92%.

Historical Net Interest Margins

The Federal Financial Institutions Examination Council (FFIEC) releases an average net interest margin figure for all U.S. banks on a quarterly basis. Historically, this figure has trended downward while averaging about 3.8% since first being recorded in 1984. Recessionary periods coincide with dips in average net interest margins while periods of economic expansion have witnessed sharp initial increases in the figure followed by gradual declines. The overall movement of the average net interest margin has moderately tracked, at a delay, the movement of the federal funds rate over time—although Fed economists have released research challenging the idea that banks perform better during periods of tight monetary policy. 

After the financial crisis of 2008, banks in the United States operated under decreasing net interest margins due to the falling federal funds rate, a benchmark interest rate that reached near-zero levels from 2008 to 2016. The markedly low federal funds rate forced the net interest spreads of banking institutions to decrease, and during this recession, the average net interest margin for banks in the U.S. shed nearly a quarter of its value before finally picking up in 2015.

U.S. Banks and Net Interest Margin

The U.S. Federal Reserve tracks the average of net interest margin of all U.S. banks each quarter. It calculates the figure using data collected by the FFIEC. The central bank reported the average net interest margin of all U.S. banks at the end of the first quarter of 2019 was 3.36%.

Net interest margins for the top three U.S. banks for the quarter ending Mar. 31, 2019 were:

  • JP Morgan Chase: 2.88%
  • Bank of America: 2.64%
  • Wells Fargo: 3.1%

The average of the top three—2.87%—was below the national average. Capital One, which ranks among the top 10 banks in the country, though, had a net interest margin of 7.22%. Along with checking and savings accounts, the bank is a major credit card, auto loan, and home loan provider.