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 calculated as:
Net Interest Margin
BREAKING DOWN Net Interest Margin
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 that an entity has invested its funds efficiently while a negative return implies that the bank or investment firm has not invested efficiently. In a negative net interest margin scenario, the company would have been better served by applying the investment funds toward outstanding debt or utilizing the funds for more profitable revenue streams.
For example, 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 would then be -10%. This reflects the fact that ABC Corp has lost more money due to interest expenses than it's earned from investments. In this case, ABC Corp would have fared better had it used the investment funds to pay off debts rather than to make this investment.
Net Interest Margin and Retail Banking
Net interest margin is well explained by illustrating how a retail bank earns interest from customers' 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. If the bank has $1 million in deposits with a 1% annual interest to depositors, and it loans out $900,000 at an interest of 5% with earning assets of $1.2 million, the net interest margin is 2.92% [(interest revenue — interest expenses) / average earning assets].
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 have coincided 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 were operating 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.