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What is a Net Interest Margin?
Malcolm Tatum
Malcolm Tatum
A net interest margin is a measurement of the difference between the revenue generated by investments and the amount of debt obligations associated with those investments. Businesses assess this type of margin as a means of determining if they are making more money than they are losing. In like manner, a bank would look closely at the difference between the generated interest income and the amount of interest they pay out to depositors in order to determine if the bank if earning more than it is paying out. Typically expressed as a percentage, the net interest margin indicates whether current strategies are working, or if changes should be made to reverse a negative trend.
A simple way to understand how a net interest margin is calculated would be to consider the difference between the interest income earned by a bank on loans to customers and the amount of interest that is paid out to depositors. Assuming the bank had total loans of $100,000 US dollars (USD) during a given day, and earned interest income that amounted to $5,000 USD while paying $3,000 USD in interest, the bank would earn a net interest margin of 2%. In this scenario, the bank experienced a 2% gain on its investment activity in regard to the loans, indicating that writing the loans has in fact generated a return on that investment.
At times, a net interest margin may indicate that a particular investment strategy is not working. For example, if the bank had earned less interest income from the issued loans than the amount of interest paid to depositors, the percentage of the margin would be negative. At that point, the bank would need to reassess how it does business, since the investment in the loans is not providing enough income to offset the amount of interest due to depositors. Unless changes are made within a reasonable period of time, the bank may find it necessary to restrict or eliminate certain bank services, or possibly close altogether.
While the net interest margin is only one of several indicators of the financial stability of a company or a financial institution, the calculation can provide insight into what investments are generating a decent amount of return and which are not performing up to expectations. By using this simple formula to evaluate the current level of return versus the debt, it is easier to identify where to make changes in order to improve the overall financial well-being of the organization.
Malcolm Tatum
After many years in the teleconferencing industry, Michael decided to embrace his passion for trivia, research, and writing by becoming a full-time freelance writer. Since then, he has contributed articles to a variety of print and online publications, including WiseGEEK, and his work has also appeared in poetry collections, devotional anthologies, and several newspapers. Malcolm’s other interests include collecting vinyl records, minor league baseball, and cycling.
Learn more...
Malcolm Tatum
After many years in the teleconferencing industry, Michael decided to embrace his passion for trivia, research, and writing by becoming a full-time freelance writer. Since then, he has contributed articles to a variety of print and online publications, including WiseGEEK, and his work has also appeared in poetry collections, devotional anthologies, and several newspapers. Malcolm’s other interests include collecting vinyl records, minor league baseball, and cycling.
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Discussion Comments
Of course the net interest margin is not the only indicator of financial stability, but I think that it's still the primary one for many institutions. It's an important basic calculation that economists and investors use and it's one of the first things I teach my students in Banking courses.
There is also something called the noninterest margin. The net interest margin shows how much profit an institution is making from interest. The noninterest margin is exactly what the name says. It's the profit that the institution makes from activities other than interest. It's calculated the same way, by subtracting noninterest expenses from noninterest income.
Together, these two measurements not only show how much profit the institution is making, but also how much its capital and assets are worth. I think this is enough information to figure out how an institution is going to do in the short term and long term. The higher the net interest margin and the noninterest margin is for an institution, the better its future looks.
@burcidi-- I think banks have a negative net interest rate when market conditions change and the bank is not competitive in the market anymore.
As you pointed out, the bank may not be able to increase interest rates on current loans if it is a fixed rate. I suppose it could try and encourage more borrowing by reducing interest rates, but it's going to need even more borrowers than it regularly would to make the same amount of money.
There are different things the banks could do, but the bottom line to maintaining a positive net interest margin for banks is to remain competitive. It could change how it manages loans, seek help from the government or merge with other banks. If it doesn't do anything to change the negative margin though, it could end up having to close its doors like the article said.
If a bank was experiencing a negative net interest margin, what will it do? Will it increase the interest rate for the loans it has given out (if that's possible) or will it reduce interest rates so that there will be more borrowers?
I was a part of an economic computer simulation once. And from what I remember there, if the banks were losing more money then they actually made, they generally increased their interest rates for more profit. But what ended up happening was that fewer firms were interested in borrowing from them because there were competing banks with lower interest rates. Banks in trouble that actually lowered loan interest rates ended up getting themselves out of trouble because more firms borrowed and their negative net interest margin became positive.
I'm not sure if it would really work like this in real life though.
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