What Is Net Interest Margin? Overview, Formula, Example

What Is Net Interest Margin?

Net interest margin (NIM) is a measurement comparing the net interest income a financial firm generates from credit products like loans and mortgages, with the outgoing interest it pays holders of savings accounts and certificates of deposit (CDs). Expressed as a percentage, the NIM is a profitability indicator that approximates the likelihood of a bank or investment firm thriving over the long haul. This metric helps prospective investors determine whether or not to invest in a given financial services firm by providing visibility into the profitability of their interest income versus their interest expenses.

Simply put: a positive net interest margin suggests that an entity operates profitably, while a negative figure implies investment inefficiency. In the latter scenario, a firm may take corrective action by applying funds toward outstanding debt or shifting those assets towards more profitable investments.

Calculating Net Interest Margin

Net interest margin may be calculated by the following formula:

 $\begin{aligned} &\text{Net Interest Margin} = \frac { \text{IR} - \text{IE} }{ \text{Average Earning Assets} } \\ &\textbf{where:} \\ &\text{IR} = \text{Investment returns} \\ &\text{IE} = \text{Interest expenses} \\ \end{aligned}$​Net Interest Margin=Average Earning AssetsIR−IE​where:IR=Investment returnsIE=Interest expenses​

Consider the following fictitious example: Assume Company ABC boasts a return on investment of $1,000,000, an interest expense of $2,000,000, and average earning assets of $10,000,000. In this scenario, ABC's net interest margin totals -10%, indicating that it lost more money due to interest expenses than it earned from its investments. This firm would likely fare better if it used its investment funds to pay off debts rather than making this investment.

What Affects Net Interest Margin

Multiple factors may affect a financial institution's net interest margin—chief among them supply and demand. If there's a large demand for savings accounts compared to loans, the net interest margin decreases, as the bank is required to pay out more interest than it receives. Conversely, if there's a higher demand for loans versus savings accounts, where more consumers are borrowing than saving, a bank's net interest margin increases. Banks and other financial institutions may also use maturity transformation to profit from the difference in interest rates between borrowing and lending funds.

Monetary policies set by central banks also heavily influence a bank's net interest margins because these edicts play a pivotal role in governing the demand for savings and credit. When interest rates are low, consumers are more likely to borrow money and less likely to save it. Over time, this generally results in higher net interest margins. Contrarily, if interest rates rise, loans become costlier, thus making savings a more attractive option, which consequently decreases net interest margins.

Net Interest Margin and Retail Banking

Most retail banks offer interest on customer deposits, which generally hovers around 1% annually. If such a bank marshaled together the deposits of five customers and used those proceeds to issue a loan to a small business, with an annual interest rate of 5%, the 4% margin between these two amounts is considered the net interest spread. Looking one step further, the net interest margin calculates that ratio over the bank's entire asset base.

Let's assume a bank has earning assets of $1.2 million, $1 million in deposits with a 1% annual interest to depositors, and loans out $900,000 at an interest of 5%. This means its investment returns total $45,000, and its interest expenses are $10,000. Using the aforementioned formula, the bank's net interest margin is 2.92%. With its NIM squarely in positive territory, investors may wish to strongly consider investing in this firm.

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 coincide 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 tracked the movement of the federal funds rate over time. Case in point: following the financial crisis of 2008, U.S. banks operated under decreasing net interest margins due to a falling rate that reached near-zero levels from 2008 to 2016. 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 again in 2015.