What is Net Interest Income?
Net interest income is defined to the difference between interest revenues and interest expenses.
For financial institutions, interest revenues represent the interest payments the bank receives on their interest-bearing assets, while interest expenses are the cost of servicing interest payments to customers on their deposits.
- Net interest income is defined as the difference between interest revenues and interest expenses.
- Interest revenues are payments that the bank receives from their interest-bearing assets, and interest expenses are the cost of servicing interest payments to customers on their deposits.
- When interest rates are increasing in the economy, net interest margins become larger. When interest rates are decreasing in the economy, net interest margins become smaller.
What Type of Assets Generate Interest Income for Investors?
Interest is defined as the difference between the purchase price and sale price. If interest rates in the economy drop and Treasury bills are sold before maturity, a capital gain will arise.
Indexed securities offer an interest rate at a discount to the market rate, and the payable balance is adjusted at maturity for inflation.
At maturity, if the adjustment is positive, it is included in interest income. If the adjustment is negative, it will be deductible, given the satisfaction of the criterion for interest rate deductibility.
Hybrid Financial Instruments
Hybrid financial products offer a guaranteed return on a pre-determined date based on the movement of a pre-specified market index, paid at maturity. Often, there are covenants, such as maximum interest, minimum interest, and exercise period, attached to the financial products.
What Type of Assets Generate Interest Income for a Bank?
For many financial institutions, the net interest margin is a primary source of income. The banks’ net interest margin can be interpreted as the cost of financial intermediation. Therefore, it is the difference between what borrowers pay for their loans and what they receive from lending.
Simply put, banks are risk-averse middlemen between depositors and borrowers of funds. Banks offer the following common financial products:
- Commercial and Personal Loans
- Construction Loans
- Investment Securities
Interest revenue is generated through interest payments that the bank receives on outstanding loans. It is made up of credit lines and loans that the institution has on its balance sheet.
Calculating Interest Revenue
Interest revenue is calculated through the application of the effective interest rate to the gross carrying amount of the financial assets. There are only two exceptions in this calculation:
- Financial assets that were credit-impaired at purchase
- Financial assets that are credit-impaired
Interest Revenue = Effective Interest Rate * Financial Asset
- Financial Asset is valued at its gross carrying amount
Interest expense is the price that the lender charges the borrower in a financing transaction or the cost of borrowing money. It is the interest that accumulates on outstanding liabilities. Common examples include customer deposits and wholesale financing.
Calculating Interest Expense
To calculate the interest expense, multiply the effective interest rate by the gross carrying amount of financial liabilities.
Interest Expense = Effective Interest Rate * Financial Liability
Net Interest Margin
Net interest margin refers to the difference between the interest income generated and the amount of interest paid out to lenders. It is an industry-specific profitability ratio for banks and other financial institutions that lend out interest-earning assets.
Net Interest Margin = [Interest Revenue – Interest Expense] / Average Earning Assets
Interest Rates in the Economy and Net Interest Income
The equilibrium interest rate is primarily impacted by the demand for borrowing capital and the supply of capital that is being lent. Increasing interest rates benefit banks by increasing their net interest income.
Therefore, in periods of low interest rates, banks have lower net interest margins. Generally, a positive net interest margin is indicative of a bank that efficiently invests its capital, whereas a negative net interest margin signifies inefficiency.
Financial Institutions Shift Away from Interest Income
Declining interest rate margins for banks have altered how institutions structure their operations. Banks have been able to increase non-interest income through trading, services, and other financial operations.
Banks diversify their source of revenue thanks to financial stabilization and increase financial deregulation.
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