Net Interest Income
We all get curious at some point to know how the bank earns after providing us with interest on the deposited money. Net interest income is one of the methods banks use to make money and handle their banking operation.
What is Net Interest Income?
NII is defined as the difference between the revenue generated on interest-bearing assets and interest-bearing liabilities. Interest-bearing assets such as corporate, personal, home loans help earn revenue for banks. Banks pay interest on the consumer deposits by the interest they collect on the distributed loans; the remaining amount is net interest income.
Earning interest is the primary operation of a bank, and other income sources are considered secondary sources of their income.
In simple words, first, they receive interest on a loan they have given out. Then they give interest to the people who have deposited their money with the bank. Generally, the interest that borrowers have to pay on their loans is more than interest they get on their deposits.
Suppose a bank with an average outstanding loan portfolio amounting to ₹600 crores.
The "average" is calculated as the sum of the beginning and end-of-period values of the bank's outstanding loans divided by two.
We are assuming a hypothetical average interest rate on loans at 4.0%.
- Loan Portfolio = ₹600 crores.
- Interest Rate = 4.0%
As for the customer deposits at the bank, the average value is ₹200 crores, and the interest rate is 1.0%.
- Loan Portfolio = ₹200 crores
- Interest Rate = 1.0%
The next step
- Interest Income = ₹600 crores * 4.0% = ₹24 crores
- Interest Expense = ₹400 crores * 1.0% = ₹4 crores
Now, the difference between the bank's interest income and interest expense would be the net interest income.
- Net Interest Income = ₹24 crores - ₹4 crores = ₹20 crores
Net Interest Income Formula
Net Interest Income = Interest Received – Interest Paid
Let's dive deep into the concept and understand what the elements of net interest income mean:
Banks earn interest revenue by receiving and collecting interest payments on the distributed outstanding loans.
The effective interest rate on the gross carrying amount of financial assets forms interest revenue.
Interest Revenue = Effective Interest Rate * Financial Asset.
Effective interest rate is the return on an investment or the rate owed in interest on a loan when compounding is taken into account.
A financial asset is a money lent to the borrower as commercial and personal loans and construction loans.
Interest expense is the cost of borrowing money that the lender charges the borrower in a financing transaction. It can be the interest that accumulates on outstanding liabilities.
Customer deposits and wholesale financing are a few common examples.
Interest Expense = Effective Interest Rate * Financial Liability.
Importance of Net Interest Income
- NII also works as a financial performance measure for banks. With the growing interest in the economy, net interest margins are bigger & vice versa.
- One can understand the quality of the loan portfolio, the effect of interest rate changes on the bank's profitability, etc., with the help of NII.
- Analyzing NII reveals a bank's financial health while investing money in banking stocks as an investor.
- Non Performing Assets have a significant impact on the NII of a bank. Hence, NII can be used to evaluate the quality of the bank's assets.
Net Interest Margin
NIM shows the amount of money a bank is earning in interest on loans compared to the amount it pays in interest on deposits. Net interest margin indicates the bank's profitability and growth.
Banks, financial institutions, and other interest-earning asset lenders consider this an industry-specific profitability ratio.
Net Interest Margin = [Interest Revenue – Interest Expense] / Average Earning Assets
Average Earning Assets are the average earning assets. Simply take the average of the beginning and ending asset balance.
Increasing interest rates in the economy bring more significant net interest margins, whereas decreasing interest rates in the economy show shorter net interest margins.
A positive net interest margin implies the bank efficiently investing its capital. A negative net interest margin signifies the inefficiency of the bank.
Factors driving the NII
- Variable rates on assets and liabilities are more fragile to changes in interest rates, thereby influencing and causing greater changes in the NII.
- NPAs of the bank affect the NII.
- An increasing gap between the rate of assets and liabilities helps the interest income rise more interest expenses pushing the NII value upward.
Frequently Asked Questions
Is net interest income the same as gross income?
Gross interest is the headline interest rate received on a loan or paid on a fixed-income investment before any fees or taxes are taken into consideration. Taxes, fees, and other expenses are subtracted from the gross interest to calculate net interest.
Why is net interest income necessary?
The quality of a loan's portfolio can be understood by NII only. If NII is high, it means the bank has quality loans and less chance of non-performing assets. When interest rate increases in the economy, net interest margins become higher and vice versa.
What is NII risk?
Interest rates impact a bank's earnings by changing its net interest income and interest-sensitive income and expenses (NII). This risk is fundamental to the banking industry, and effective management can significantly affect revenue and shareholder value.