The Power of Net Interest Rate Spread
The net interest rate spread is the difference between the yield that a financial institution receives from loans and other interest-accruing activities and the rate it pays on deposits and borrowings. This spread is a vital element of a financial institution’s profitability.
Key Points
- The net interest rate spread is the difference between the interest rate a bank pays and the interest rate it receives from its income-generating activities.
- It plays a crucial role in a bank’s profitability.
- It can be visualized as the profit a bank makes within a given period.
Grasping the Concept of Net Interest Rate Spread
Loan-granting institutions, like commercial banks, generate interest income from several sources. Core deposits (such as checking and savings accounts or certificates of deposit) are usually sourced at lower rates. Banks also gather funds through means like shareholder equity, wholesale deposits, and debt issuance. Various loans, including mortgages, home equity lending, student loans, car loans, and credit card lending, are then issued at higher interest rates.
A bank’s core business involves managing the spread between the interest rate on deposits it pays consumers and the rate it gains from loans. When the interest a bank earns from loans surpasses the interest it pays on deposits, it profits from the interest rate spread. Essentially, net interest rate spreads are comparable to profit margins.
The wider the spread, the more profitable the institution is likely to be. This simplistic view hinges on financial institutions employing strategies for customer acquisition, retention, loyalty, and principal investing to outpace their rivals. Hence, the net interest rate spread in monetary terms resembles a non-financial business’s gross profit, reflecting its profitability after costs.
Calculating the Net Interest Rate Spread
To compute the interest rate spread, you use the average rate of a bank’s interest-bearing liabilities and the yield for its interest-earning assets. The formula is:
Interest Rate on Assets - Interest Rate on Liabilities = Net Interest Rate Spread
Where:
- Interest Rate on Assets: The yield the bank is paid on interest-earning assets.
- Interest Rate on Liabilities: The rate the bank pays on interest-bearing liabilities.
For example, in 2022, if a bank earned $31.24 billion in interest income with a 7.68% yield while its interest-bearing liabilities totaled $4.12 billion with a 1.25% yield, it would have an interest rate spread of 6.43%, translating to $27.1 billion in income from these activities.
Comparing Net Interest Rate Spread and Net Interest Margin
Net interest margin differs slightly as it accounts for additional funding sources or income not covered by standard corporate accounting definitions, such as investments or non-interest-bearing accounts. For example, a bank might have an interest rate spread of 6.43%, but adjusting for 0.24% in non-interest-bearing funding results in a net interest margin of 6.67%.
Defining Interest Rate Spread
Interest rate spread refers to the gap between the interest rates charged to customers and the rates a bank pays other banks for borrowing money.
Illustrative Example of Bank Spread
Consider a scenario where Bank A earns a 5.25% average interest on interest-earning assets and pays 1.25% on interest-bearing liabilities, resulting in a bank spread of 4.0%.
Calculating Your Net Interest Rate Spread
Financial institutions calculate net interest rate spread by taking the yield on interest-earning assets and subtracting the rate on interest-bearing liabilities.
Final Thoughts
Net interest rate spread offers insights into banks’ profitability. Though a solid indicator of financial performance for a particular period, it should be analyzed in conjunction with other metrics for a comprehensive evaluation.
Related Terms: Net Interest Margin, Interest Rate Spread, Bank Spread, Interest-Earning Liabilities, Interest-Bearing Assets.
References
- Capital One Financial Corporation. “Annual Report 2022”, Page 50.
- Capital One Financial Corporation. “Annual Report 2022”, Page 49.
