Banks have a number of measures, different from those used to analyze industrial companies, that investors can use to evaluate performance. One of the most basic of these is the net interest margin.
The net interest margin, also sometimes referred to as the net yield on interest-earning assets, is usually defined as tax-equivalent net interest income, divided by average interest-earning assets. The margin is calculated for a period of time, a quarter or a year, and is expressed as a percentage.
Net interest income, the numerator of the equation, is the total interest income earned on a bank’s loans, investment securities, and short-term investments (like on interest-bearing deposits with other banks) during a period of time, minus the cost of (interest expense related to) the funds used to make loans and investments. The usual sources of interest-bearing funds include deposits and short- and long-term borrowings. Since banks’ investment securities typically include some tax-free bonds, net interest income is adjusted for taxes, to put interest income from all sources on the same pretax (tax-equivalent) basis.
Average interest-earning assets, the denominator of the ratio, consists of an average of all of a bank’s assets that generate interest income during a specific time period. This excludes certain assets, like property and cash on deposit with the Federal Reserve Bank to meet reserve and clearing requirements, that don’t earn interest income.
The net interest margin is often confused with the net interest-rate spread, although some banks refer to the spread or tax-equivalent net interest income as the margin. The difference between the average interest rate on all of a bank’s interest-earning assets and the interest rate on all of its sources of funds is usually called the net interest-rate spread. The spread doesn’t take into account the size of the interest-earning asset base. The margin, which does, can change when the interest-earning asset base expands or contracts. It is the bank’s return on its assets that generate interest income.
The net interest margin is not a measure of a bank’s total profitability since most banks also earn fees and other non-interest income from providing services, like brokerage and deposit account services, and it doesn’t take operating expenses, like personnel and facilities costs, or credit costs into account.
The net interest margin can be used to track the profitability of a bank’s investing and lending activities over a time period. Like conventional profit margins, wider is better. BB&T (BBT), a bank based in North Carolina, was able to expand its net interest margin, from 3.58% in 2008 to 3.66% in 2009. Although the yields on its assets that generate interest income declined, it increased its reliance on low-cost deposits and short-term debt, and reduced its use of higher-cost long-term debt, lowering its funding costs more than the interest income on its loans and investments. Despite the margin improvement, earnings still declined in 2009, due to higher expenses and credit costs.
Comparisons between the net interest margins of different banks are not always meaningful since the margin reflects the bank’s unique profile, that is, the nature of its activities, the composition of its customer base, and its funding strategies. No two banks are exactly the same. On one end of the range, the widest net interest margins probably would be found at banks with traditional lending and deposit businesses, that is, those for which loans make up the bulk of their interest-earning assets (loans, especially to consumers, typically have higher interest rates than investment securities and other short-term investments) and banks that fund their interest-earning assets mostly with deposits rather than higher-cost borrowed funds. Such banks include Missouri-based Commerce Bancshares (CBSH), which had a net interest margin of 3.93% in 2009. Loans accounted for nearly 64% of that bank’s average interest-earning assets, and deposits made up the lion’s share of its sources of funds.
Meanwhile, State Street (SST), a non-traditional bank whose main business is providing asset management and support services to institutional investors, had a net interest margin of 2.19% in 2009. State Street doesn’t make consumer loans, and lends only as a courtesy to its commercial customers. Investment securities generate most of its net interest income, but in State Street’s case, its securities yield more than its loans. And foreign deposits that bear interest at very low rates comprise a large portion of its funding. Interestingly, the size of State Street’s average interest-earning asset base influenced its margin in 2009. State Street’s net interest income declined 2.4% between 2008 and 2009, but it earned that income using a smaller average interest-earning asset base (that contracted 7.3%), allowing the net interest margin to expand to 2.19% , up from 2.08% in 2008.
Bank balance sheets are often described in terms of their relative responsiveness to changes in short-term interest rates. Banks whose interest-earning assets (loans and investments) tend to reprice more quickly when short-term interest rates change than their interest-bearing deposits and borrowed funds are said to be asset sensitive. They tend to do well when interest rates rise, but their margins are squeezed when short-term interest rates decline.
Banks whose liabilities reprice more quickly than their assets are liability sensitive. They probably would have benefited from the decline in short-term interest rates over the 2008 to 2009 period.
Banks that strike a balance between the two are described as interest-rate neutral. Texas-based Cullen/Frost Bankers (CFR), whose balance sheet historically was asset-sensitive, used interest-rate swaps in 2009 to move to a more interest-rate neutral position, thereby mitigating the negative effect of declining interest rates on the margin and net interest income.
The trend in the net interest margin gives a bank investor a quick look at the profitability of the bank’s lending and investing activities. Some bank investors may want to dig deeper, to investigate the reasons for changes in the margin. In addition to a period-end balance sheet, banks also publish average balance sheets that span a period of time and show the breakdown of a bank’s loans, investments, deposits, and borrowed funds, and their related interest rates. The average balance sheet, and accompanying financial discussion in bank earnings reports, should give investors more insight into the interesting, but complex, workings of a bank.